Discussion of Aguiar Amador, Farhi and Gopinath

1. Discussion of Aguiar Amador, Farhi and Gopinath Coordination and Crisis in Monetary Unions

2. In a nutshell • Very nice contribution • Clarification of some types of interactions between monetary and fiscal policy • Euro area experience has shown it is a key issue. • Implications for optimal composition of a currency area (low debt/high debt countries)

3. Set up • Lack of commitment and lack of coordination between a continuum of fiscal authorities and the unique monetary authority • Each member country defines its fiscal policy (consumption saving decision and exogenous inflation costs) separately from other countries. • It does not take into account the effect of its decision on total debt in the union: “fiscal externality” • The Central Bank is modelled as an aggregator of fiscal authorities. • Monetary policy (inflation) is set centrally by the Central Bank and depends on total debt in the union. Inflation is constrained by an upper exogenous limit.

4. Ideas • Deterministic case with no roll over risk • Threshold equilibrium with Central bank inflating (to the upper limit) above but not below the threshold • Since the debt is continuously rolled over adjustment on the nominal rate immediately nullifies the effect of inflation on debt • One is left with the deadweight cost of inflation

5. Implications • In the deterministic case with no roll over risk: a country is better off with low debt countries in a monetary union as the incentives to inflate are lower. • In presence of rollover risk: a country wants low inflation in normal times but high inflation in crisis times • Monetary authority more tempted to inflate if more countries with high debt. • So the optimal composition of the currency area is “intermediate” for a high debt country

6. It is nice that the paper… • Illuminates the effects due purely to the absence of commitment --- It compares the Ramsey economy (zero inflation) versus the small open economy case with integrated fiscal and monetary authority but no commitment) --- • Versus the effects due to the absence of commitment and of coordination (Monetary Union) • In the latter case, there is a discrete welfare jump as an individual country does not internalize the effect of increasing savings marginally to get to the low inflation equilibrium (fiscal externality)

7. Roll over risk • Modeling trick: • Exogenous possibility of rollover risk • “Grace” period of exogenous length during which countries cannot borrow but may choose to repay their debt at the interest rate it was contracted upon • This is why inflating the debt will work during the grace period (it will have real effects) • Multiple equilibrium: if governments default, debt goes down so monetary authority will not inflate and repayment is tough • If governments do not default, then monetary authority may inflate and make repayment easier during the “grace period” (as interest rate on debt arrears is constant) • Equilibrium selection (“default externality” is somewhat internalized): largest non default zone (“members of union believe Central bank will help”)

8. Key results of the general model • If many indebted countries, Central Bank always inflates hence the nominal interest rate always prices inflation and there is no gain. The inflation cost is paid and there is no reduction in real rate during the “grace” period times • If there are very few indebted countries, the Central bank never inflates and this makes repayment difficult if a rollover crisis occurs • If there is an intermediate number of highly indebted countries: the Central Bank will inflate in crisis times, which is beneficial because grace period interest rate does not adjust and hence real burden is decreased and it will keep inflation low in normal times, which will save the inflation costs. • Optimal composition of a currency area follows (though there are many equilibria ) • Question: It is assumed that debt is repaid exactly at the end of the grace period. Can it be optimal to repay it earlier to switch back to normal regime earlier?

9. Which monetary union? • The paper has lots of references to the euro area to motivate the analysis but: • Continuum of small open economies which do not intract with one another except via the response of the Central Bank to their policies • no flexible exchange rate of the union vis-a-vis ROW (r*): MU small in world financial markets • Convergence of real rates is assumed (arbitrage condition r*=r+ expected inflation plays a key role in the analysis). There are massive divergence in real rates in the euro area (indeed it is probably a cause of the crisis) • Objective function of the Central Bank seems far from the institutional set up of the euro area • Rollover risk : independent of r* for example, of debt levels • How important is assumption (investors opportunity cost is equal to the discount rate of monetary and fiscal authorities)?

10. So… • It does not look like the euro area • It does not matter • But the language should be adjusted a bit

11. Robustness • Many equilibria (even in the class of symmetric ones). Problem of equilibrium selection. • In the model could a simple way of solving the commitment problem be to issue debt in foreign currency? Rollover risk is of course then an issue. It could be interesting to look a this. • Key assumption: the debt is continuously rolled over; hence interest rates paid reflect immediately inflation except in the grace period. There could be different timing assumptions reflecting better the differences in debt maturity structures/ the effect of “financial repression” (see Reis et all. )

12. Robustness • Role of the Central Bank: in the paper it takes inflationary expectation as given instead of setting them (inflation targeting framework) • Exogenous upper limit set on inflation plays a role (bang bang solution). If this limit was increased then we will go all the way (hyperinflation). This is not a short cut for inflation targeting as objective function would be quite different. • In the paper the role of the lender of last resort (against rollover risk) is to inflate. This would of course be at odds with the role of a Central Bank targeting inflation. • Since debt is exogenously given in the paper, moral hazard issues are not much discussed. This is obviously an important consideration in practice.

13. Another way of thinking about the lender of last resort function • Instead of inflating….the Central Bank buys risky country debt and issues sterilization bills (money supply unchanged) to go back to the safe no crisis zone • This is equivalent to replacing a default prone asset with a default free one • For this to be true it requires that the interest payments on the sterilization bills be consistent with seigniorage revenues of the Central Bank given its inflation target • Moral hazard issues as above.

14. Conclusions • Very nice paper which generates lots of thinking… • As very nice papers do.