Exit Expectations and Debt Crises in Currency Unions
59 Pages Posted: 16 Sep 2015
Date Written: September 2015
Membership in a currency union is not irreversible. Expectations of exit may emerge during a sovereign debt crisis, because by exiting countries can redenominate and reduce their liabilities. This possibility alters the dynamics of sovereign debt crises. We establish this formally within a small open economy model of changing policy regimes. The model permits explosive dynamics of debt and sovereign yields inside the currency union and allows us to distinguish between exit expectations and those of an outright default. By estimating the model on Greek data, we quantify the contribution of exit expectations to the crisis dynamics during 2009-2012.
Keywords: currency union, euro crisis, exit, fiscal policy, redenomination premium, regime-switching model, sovereign debt crisis
JEL Classification: E41, E52, E62
Suggested Citation: Suggested Citation