Cross-Border Banking and Business Cycles in Asymmetric Currency Unions

Against the background of the emergence of macroeconomic imbalances within the European Monetary Union (EMU), we investigate in this paper the macro-economic consequences of cross-border banking in monetary unions such as the euro area. For this purpose, we incorporate in an otherwise standard two-region monetary union DSGE model a global banking sector along the lines of Gerali et al. (2010), accounting for borrowing constraints of entrepreneurs and an internal constraint on the bank’s leverage ratio. We illustrate in particular how rule-of-thumblending standards based on the macroeconomic performance of the dominating region within the monetary union can translate into destabilizing spill-ove r effects into the other region, resulting in an overall higher macroeconomic volatility. Thereby, we demonstrate a channel through which the financial sector may have exacerbated the emergence of macroeconomic imbalances within the EMU. This effect may be partly mitigated if the central bank reacts to loan rate spreads, at leastrelative to the case with constant lending standards.