Sovereign Default in a Monetary Union

56 Pages Posted: 11 Jun 2018

See all articles by Sergio de Ferra

Sergio de Ferra

Stockholm University

Federica Romei

Luiss Guido Carli University

Date Written: June 2018

Abstract

In the aftermath of the global fi nancial crisis, sovereign default risk and the zero lower bound have limited the ability of policy-makers in the European monetary union to achieve their stabilization objective. This paper investigates the interaction between sovereign default risk and the conduct of monetary policy, when borrowers can act strategically and they share with their lenders a single currency in a monetary union. We address this question in an endogenous sovereign default model of heterogeneous countries in a monetary union, where the monetary authority may be constrained by the zero lower bound. We uncover three main results. First, in normal times, debtors have a stronger incentive to default to induce more expansionary monetary policy. Second, the zero lower bound, or constraints on monetary policy, may act as a disciplining device to enforce repayment of sovereign debt. Third, sovereign default risk induces countries with a preference for tight monetary policy to accept a laxer policy stance. These results help to shed light on the recent European experience of high default risk, expansionary monetary policy and low nominal interest rates.

Keywords: Heterogeneous Countries, monetary union, sovereign default, zero lower bound

JEL Classification: F34, F42, F45, H63

Suggested Citation

de Ferra, Sergio and Romei, Federica, Sovereign Default in a Monetary Union (June 2018). CEPR Discussion Paper No. DP12976. Available at SSRN: https://ssrn.com/abstract=3193979

Sergio De Ferra (Contact Author)

Stockholm University

Federica Romei

Luiss Guido Carli University ( email )

Via O. Tommasini 1
Rome, Roma 00100
Italy

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