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Sovereign Default in a Monetary Union

Sergio de Ferra and Federica Romei

No 12976, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: In the aftermath of the global fi nancial crisis, sovereign default risk and the zero lower bound have limited the ability of policy-makers in the European monetary union to achieve their stabilization objective. This paper investigates the interaction between sovereign default risk and the conduct of monetary policy, when borrowers can act strategically and they share with their lenders a single currency in a monetary union. We address this question in an endogenous sovereign default model of heterogeneous countries in a monetary union, where the monetary authority may be constrained by the zero lower bound. We uncover three main results. First, in normal times, debtors have a stronger incentive to default to induce more expansionary monetary policy. Second, the zero lower bound, or constraints on monetary policy, may act as a disciplining device to enforce repayment of sovereign debt. Third, sovereign default risk induces countries with a preference for tight monetary policy to accept a laxer policy stance. These results help to shed light on the recent European experience of high default risk, expansionary monetary policy and low nominal interest rates.

Keywords: Heterogeneous Countries; monetary union; sovereign default; zero lower bound (search for similar items in EconPapers)
JEL-codes: F34 F42 F45 H63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-eec, nep-knm, nep-mon and nep-opm
Date: 2018-06
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