The Effects of a Payments Union: A Stochastic Analysis

Abstract

In the benchmark model of Chapter 3, we examined the impact of a clearing union on the international budget constraint of a soft-currency member country. Payments unions differ from clearing unions in providing for the multilateral extension of credit from regional surplus countries to regional deficit countries beyond the clearing periods. In order to model the effects of such medium-term credit extension, it is necessary to extend the benchmark model to a multi-period setting in which the value of international payments obligations is stochastic rather than deterministic. We develop such a stochastic model of international payments in Section 4.1, and use it in Section 4.2 to demonstrate the effect of a payments union on the international budget constraint of member countries. In Section 4.3 we show that a payments union is likely to reduce the demand for precautionary balances of foreign exchange among member countries.