Sovereign Risk and Belief-Driven Fluctuations in the Euro Area

50 Pages Posted: 10 Dec 2013

See all articles by Keith Kuester

Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Gernot J. Müller

University of Tuebingen - Department of Economics

Andreas Billmeier

International Monetary Fund (IMF) - Middle East and Central Asia Department

Multiple version iconThere are 2 versions of this paper

Date Written: November 2013

Abstract

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

Kuester, Keith and Corsetti, Giancarlo and Müller, Gernot J. and Billmeier, Andreas, Sovereign Risk and Belief-Driven Fluctuations in the Euro Area (November 2013). IMF Working Paper No. 13/227. Available at SSRN: https://ssrn.com/abstract=2365870

Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Giancarlo Corsetti

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
Italy
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Gernot J. Müller

University of Tuebingen - Department of Economics ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

Andreas Billmeier

International Monetary Fund (IMF) - Middle East and Central Asia Department ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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