Currency Risk in Currency Unions

36 Pages Posted: 9 Sep 2013

See all articles by Alexander Kriwoluzky

Alexander Kriwoluzky

University of Bonn - Faculty of Law & Economics

Gernot J. Müller

University of Tuebingen - Department of Economics

Martin Wolf

Financial Times

Date Written: September 2013


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

JEL Classification: E62, F41

Suggested Citation

Kriwoluzky, Alexander and Müller, Gernot J. and Wolf, Martin, Currency Risk in Currency Unions (September 2013). CEPR Discussion Paper No. DP9635, Available at SSRN:

Alexander Kriwoluzky (Contact Author)

University of Bonn - Faculty of Law & Economics ( email )

Postfach 2220
D-53012 Bonn

Gernot J. Müller

University of Tuebingen - Department of Economics ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074

Martin Wolf

Financial Times ( email )

United Kingdom

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