Sovereign Risk and Belief-Driven Fluctuations in the Euro Area
50 Pages Posted: 10 Dec 2013
Date Written: November 2013
Sovereign risk premia in several euro area countries have risen markedly since 2008, driving up credit spreads in the private sector as well. We propose a New Keynesian model of a two-region monetary union that accounts for this “sovereign risk channel.” The model is calibrated to the euro area as of mid-2012. We show that a combination of sovereign risk in one region and strongly procyclical fiscal policy at the aggregate level exacerbates the risk of belief-driven deflationary downturns. The model provides an argument in favor of coordinated, asymmetric fiscal stances as a way to prevent selffulfilling debt crises.
Keywords: Sovereign debt, Euro Area, Fiscal risk, Risk premium, Fiscal policy, Monetary policy, Economic models, Sovereign risk channel, monetary union, zero lower bound, risk premium, pooling of sovereign risk, government spending, fiscal stance, spending cuts, tax revenue, fiscal multiplier, aggregate demand, government expenditure, public debt, fiscal expansion, fiscal stress, fiscal austerity, public finances, fiscal impulse, fiscal outlook, fiscal response, fiscal policies, government deficit, fiscal stances, tax systems, fiscal risks, government budget, fiscal deficits, taxation, fiscal transfer, public expenditures, budget constraint, primary expenditure, fiscal theory, fiscal limits, expansion
JEL Classification: E62, F41, F42
Suggested Citation: Suggested Citation