Heterogeneous Countries in a Financial Union∗

A financial union is a group of countries, each with its own nontradable goods sector, which can freely exchange tradable goods and debt contracts. In this paper, we establish the effects of shocks in a stylized financial union with heterogeneous regions– a lender North and a borrower South– and constraints on borrowing. We derive positive and normative results. First, when the degree of heterogeneity is high before the shock, the South is disproportionately hurt by the shock, no matter whether the shock strikes in the North or the South. Second, for a given value of the shock, when borrowing constraints bind in the South, the welfare of the North decreases while the welfare of the South may increase. Third, we characterize which policy interventions are able to generate Pareto improvements. Unconditional debt relief for the South fails to do so. Subsidized governmental loans succeed when Southern governments can commit to repay additional debt. Finally, whether or not Southern governments can commit to repay anything, a Pareto improvement is possible using a combination of conditional debt relief and a tax/subsidy package in the South. JEL classification: F34, F36, F45