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Sovereign Default Risk in a Monetary Union

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  • Betty C. Daniel

    ()
    (University at Albany)

  • Christos Shiamptanis

    ()
    (Central Bank of Cyprus)

Abstract

A country entering a monetary union gives up the right to determine its own monetary policy, thereby relinquishing monetary instruments to assure fiscal solvency. In this paper, we develop a new theoretical model to address fiscal solvency risk. We show that when debt is subject to an upper bound and policy faces stochastic shocks, a government can find itself in a position for which the expected present value of future surpluses under current policy is less than debt. Agents refuse to lend into such a position, and the sudden stop of capital flows defines a fiscal solvency crisis. We model the dynamics of a fiscal solvency crisis in a monetary union under the assumption that the fiscal authority will respond to the crisis using default to reduce the value of debt. We simulate the model to estimate fiscal solvency risk in the European Monetary Union. We find that countries adhering to the Stability and Growth Pack limits are perfectly safe, while countries like Greece and Italy, whose debt relative to GDP has strayed far above the 60 percent limit, are not.

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Bibliographic Info

Paper provided by Central Bank of Cyprus in its series Working Papers with number 2010-3.

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Length: 46 pages
Date of creation: May 2010
Date of revision:
Handle: RePEc:cyb:wpaper:2010-3

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Web page: http://www.centralbank.gov.cy/nqcontent.cfm?a_id=1
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Keywords: European Monetary Union; sovereign default; financial crisis;

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References

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  1. Betty Daniel & Christos Shiamptanis, 2008. "Fiscal Policy in the European Monetary Union," Discussion Papers 08-11, University at Albany, SUNY, Department of Economics.
  2. Daniel, Betty C., 2001. "The fiscal theory of the price level in an open economy," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 293-308, October.
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  19. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, vol. 4(3), pages 381-99.
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Citations

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Cited by:
  1. Gros, Daniel, 2012. "A simple model of multiple equilibria and sovereign default," CEPS Papers 7174, Centre for European Policy Studies.
  2. Carolina Achury & Christos Koulovatianos & John D. Tsoukalas, 2011. "External Sovereign Debt in a Monetary Union: Bailouts and the Role of Corruption," CESifo Working Paper Series 3532, CESifo Group Munich.
  3. Daniel Gros, 2013. "Foreign debt versus domestic debt in the euro area," Oxford Review of Economic Policy, Oxford University Press, vol. 29(3), pages 502-517, AUTUMN.

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