Asset Purchases in a Monetary Union with Default and Liquidity Risks

Huixin Bi, Andrew Foerster and Nora Traum

No RWP 24-13, Research Working Paper from Federal Reserve Bank of Kansas City

Abstract: We develop a nonlinear two-country monetary union model with endogenous sovereign default and financial intermediation to study the effects of targeted asset purchases, and expectations of such programs, during sovereign debt crises. Default risk increases with government debt and shifts in investors’ perceptions of fiscal solvency. We calibrate the model to Italy and Germany during the 2012 European debt crisis; it reproduces key features of the data, including the periphery-core divergence in investment, output, and sovereign yields. Cross-border transmission depends on the substitutability of sovereign bonds: when bonds are poor substitutes, the crisis country contracts while the rest of the union expands, whereas highly substitutable bonds generate a synchronized downturn. During a debt crisis, asset purchases stabilize financial markets and the macroeconomy, and this stabilization can occur even if purchases are expected but never implemented. However, expectations of potential asset purchases can also distort normal-times activity by encouraging greater risk-taking.

Keywords: Monetary and fiscal policy interaction; 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: 54
Date: 2024-12-03, Revised 2026-07-03
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mon, nep-opm and nep-rmg
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Working Paper: Asset Purchases in a Monetary Union with Default and Liquidity Risks (2025)
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DOI: 10.18651/RWP2024-13

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