SOVEREIGN RISK IN THE EURO ZONE AND MONETARY POLICY

Eiji Okano () and Eiji Ogawa
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Eiji Ogawa: Graduate School of Commerce and Management, Hitotsubashi University, 186-8601 Tokyo, Japan

Global Journal of Economics (GJE), 2012, vol. 01, issue 02, 1-30

Abstract: We analyze monetary policy in a currency union with sovereign risk by using a three-country model including a two-country currency union and introduce anad hocassumption that one of the two countries is exposed to sovereign risk. In our model, if expected fiscal revenue is less than current public debt, one country can default whereas the other country cannot default. In a canonical setting that analyzes optimal monetary policy, the optimal monetary policy is consistent with the Taylor rule. However, the Taylor rule is not optimal and persistently causes defaults in our model. In contrast, an interest rate peg, namely government bonds swaps, terminates defaults after one period and is optimal in our model.

Keywords: Sovereign risk; European crisis; fixed-interest-rate rule; fiscal theory of price level; E52; E60; F41; F47 (search for similar items in EconPapers)
Date: 2012
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DOI: 10.1142/S2251361212500115

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