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Liquidity Crises in a Monetary Union

One of the economic drawbacks of a monetary union is the vulnerability it imposes on its members. By losing control over their currency and over the Central Bank operations, member-countries find themselves prone to insolvency and liquidity crises.

The concepts of liquidity and solvency rely on market perceptions. In general, liquidity will depend on how investors perceive the risk of insolvency for a given country. A country is solvent if it is perceived as able to repay its debt. This will happen if its future budget surpluses are expected to be over a given threshold, which depends on the current level of debt and the present value of future issuing, as well as on the interest, growth and inflation rates. The perception of solvency by the investors will also depend on whether or not the country is in a monetary union.

De Grauwe (2011) argues that, everything else constant, a country in a monetary union will be perceived as having a higher risk of default. This is due to the lack of a Central Bank that acts as a lender of last resort in order to avoid liquidity crises. If the risk of default is significant for a given country, investors holding its bonds will want to sell them, leading to an increase in their interest rate that decreases the liquidity of the country. While in general the Central Bank can provide liquidity by buying government debt, this is not the case in a monetary union, where the Central Bank is not directly controlled by the member countries. Additionally, an increase in the risk of default by a country will make holders of its currency more willing to sell it: this excess supply leads to a depreciation that helps the economy to grow. In a monetary union, this is not necessarily the case, since the value of the currency does not depend on the behaviour of a single country. These two effects mean that monetary union countries are more vulnerable to variations in market behaviour that can lead to a sudden stop. This framework is used to compare the Spanish situation with that of the UK, focusing on the Eurozone crisis that started in 2009. After the crisis the pound depreciated against the euro, namely due to a higher inflation in the UK, which helps to explain a higher growth rate for this country. Since the primary surplus needed to stabilize debt decreases with both inflation and the growth rate, the author estimated it to be higher for Spain (2,30% of GDP) than for the UK (-1,21%), even taking into account that the UK had a higher debt.

One important application of this result is that countries in a monetary union lose part of their capacity to deal with economic crisis, namely the ability to implement counter-cyclical fiscal policies: this kind of policies aims at smoothing the effects of a downturn by means of an increased government spending, leading to higher budget deficits. The higher the primary surplus required for solvency, the smaller is the deficit the country can incur to avoid a default. Thus, the need for a higher primary budget surplus impairs the country’s ability to use counter-cyclical measures.

While there are benefits associated with the implementation of a monetary union, such as reduced uncertainty associated with exchange rate fluctuations within their members, it is important to acknowledge for the problems it may pose. In particular, as discussed, the loss of independent monetary policy can make a country more vulnerable to market fluctuations, leading to limitations in the use of its other main macroeconomic instrument, fiscal policy.


De Grauwe, P. (2011), “The Governance of a Fragile Eurozone”, Economic Policy, CEPS Working Documents.

Carla Ferreira, 636

João Araújo, 638


Author: studentnovasbe

Master student in Nova Sbe

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