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The Sovereign-Bank Interaction in the Eurozone Crisis

Maximilian Goedl

No 2017-10, Graz Economics Papers from University of Graz, Department of Economics

Abstract: This paper investigates the relationship between government debt default, the banking sector and the wider economy. It builds a model of the public bond market, the banking sector and the real economy to study the mechanism by which a government default affects the other sectors and shows that this model can explain some "stylized facts" of the Eurozone crisis. The key aspect of the model is a friction in the financial market which forces banks to hold part of their assets in the form of government bonds. In such a model, an exogenous increase in the probability of default can lead to the joint occurrence of a credit crunch (i.e. declining bank lending and rising spreads between loan interest rates and deposit rates) and a decline in output. The paper also shows that an adverse technology shock (an exogenous decline in total factor productivity) cannot fully explain these phenomena.

Keywords: Government default; Financial frictions; Business cycle model (search for similar items in EconPapers)
JEL-codes: E37 E44 H63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cta, nep-dge, nep-eec and nep-mac
Date: 2017-10
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