Asset Purchases in a Monetary Union with Default and Liquidity Risks

Huixin Bi, Andrew Foerster and Nora Traum

No 2025-10, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: Using a two-country monetary union framework with financial frictions, we quantify the efficacy of targeted asset purchases, as well as expectations of such programs, in the presence of sovereign default and financial liquidity risks. The risk of default increases with the level of government debt and shifts in investors’ perception of fiscal solvency. Liquidity risks increase when the probability of default affects the tightness of credit markets. We calibrate the model to Italy during the 2012 European debt crisis and compare it to key features of the data. We find that changes in investors’ perception played a more significant role than increases in government debt in affecting the macroeconomy. When a debt crisis occurs, asset purchases help stabilize both financial markets and the economy. This stabilization effect can occur even if asset purchases are expected but never implemented. Moreover, expectations of potential asset purchases during a crisis alter the level of economic activity in periods when there are no crises.

Keywords: fiscal policy; monetary policy; unconventional monetary policy; Monetary Union; financial frictions; Regime-Switching Models (search for similar items in EconPapers)
JEL-codes: E58 E63 F45 (search for similar items in EconPapers)
Pages: 49
Date: 2025-05-07
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Working Paper: Asset Purchases in a Monetary Union with Default and Liquidity Risks (2024)
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DOI: 10.24148/wp2025-10

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