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Currency Risk in Currency Unions

Alexander Kriwoluzky, Gernot Müller and Martin Wolf ()

No 9635, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Sovereign yield spreads within currency unions may reflect the risk of outright default. Yet, if exit from the currency union is possible, spreads may also reflect currency risk. In this paper, we develop a New Keynesian model of a small member country of a currency union, allowing both for default within and exit from the union. Initially, the government runs excessive deficits as a result of which it lacks the resources to service the outstanding debt at given prices. We establish two results. First, the initial policy regime is feasible only if market participants expect a regime change to take place at some point, giving rise to default and currency risk. Second, the macroeconomic implications of both sources of risk differ fundamentally. We also analyze the 2009--2012 Greek crisis, using the model to identify the beliefs of market participants regarding regime change. We find that currency risk accounts for about a quarter of Greek yield spreads.

Keywords: currency risk; Currency union; default; euro; exit; fiscal deficits; Greek crisis; irreversibility; spreads (search for similar items in EconPapers)
JEL-codes: E62 F41 (search for similar items in EconPapers)
Date: 2013-09
New Economics Papers: this item is included in nep-mac, nep-opm and nep-rmg
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