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Regime switches under policy uncertainty in monetary unions

Canofari Paolo and Giovanni Di Bartolomeo ()

wp.comunite from Department of Communication, University of Teramo

Abstract: This paper analyzes the effects of policy uncertainty on the stability of a monetary union. Focusing on peripheral countries, we study how uncertainty over the consequences of a possible exit affects regime switches. Applying game theory and a cost-benefit analysis, we model a regime switch as the endogenous result of a two-stage policy game. We find that the effects of uncertainty are not trivial. Unilateral exits are less probable, but contagion is more likely to be observed. Our results are driven by two opposite forces: a traditional conservative effect induced by policy uncertainty in a single policymaker framework, which calls for more stability, and a strategic effect arising from the strategic interaction, which may undermine the monetary union’s foundation and strengthen incentives for contagion.

Keywords: currency crisis; common currency; contagion; multiplicative uncertainty; policy game (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mon and nep-pol
Date: 2016-11
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