Financial integration and EMU's external imbalances in a two-country OLG model

The pronounced increase in external imbalances in the European Economic and Monetary Union (EMU) during the years running up to 2008 is traditionally explained by financial integration through the common currency. This paper examines in a one-good, two-country overlapping generations' model, with production, capital accumulation and public debt, the effects of financial integration on the net foreign asset positions of initially low-interest and high-interest rate EMU countries. We find that a lower savings rate and government expenditure quota, together with a higher capital production share in the latter can in fact be transformed into the observed external imbalances when interest rates converge.