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Fiscal Risk in a Monetary Union

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  • Betty Daniel
  • Christos Shiamptanis

Abstract

A country entering a monetary union gives up the right to determine its own monetary policy. Individual fiscal authorities promise passive fiscal policy, allowing the central monetary authority to use active monetary policy. Since a government, which can print its own money, can honor its nominal debt unconditionally, entrance into a monetary union raises new issues of potential fiscal insolvency. When there is an upper bound on the magnitude of the surplus and stochastic shocks to the surplus, a government can find itself in a position in which it cannot borrow to continue with its desired passive fiscal policy. This paper considers the risk of a fiscal financial crisis in a monetary union under alternative assumptions about how the fiscal authority would respond. The response affects the timing and probability of a crisis. We consider both outright default and policy switching, whereby the fiscal authority in crisis switches to active fiscal policy and the monetary authority switches to passive monetary policy. We apply the model to estimate fiscal risk in the European Monetary Union. Using panel estimates of the parameters in the surplus rule and initial values for government debt and the primary surplus, we simulate fiscal risk under the two alternative fiscal responses to a crisis. We find that countries with initial values bound by the Maastricht Treaty limits are safe, while countries like Italy and Greece, in which debt has strayed far above these limits, might not be.

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Paper provided by University at Albany, SUNY, Department of Economics in its series Discussion Papers with number 08-12.

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Date of creation: 2008
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Handle: RePEc:nya:albaec:08-12

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Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
Phone: (518) 442-4735
Fax: (518) 442-4736

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Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
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Citations

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Cited by:
  1. Daniel, Betty C. & Shiamptanis, Christos, 2013. "Pushing the limit? Fiscal policy in the European Monetary Union," Journal of Economic Dynamics and Control, Elsevier, vol. 37(11), pages 2307-2321.
  2. Christos Shiamptanis, 2012. "Risk Assessment Under a Non-linear Fiscal Rule," Working Papers 038, Ryerson University, Department of Economics.
  3. Eric M. Leeper & Todd B. Walker, 2012. "Perceptions and Misperceptions of Fiscal Inflation," NBER Chapters, in: Fiscal Policy after the Financial Crisis, pages 255-299 National Bureau of Economic Research, Inc.
  4. Betty C. Daniel, 2010. "Exchange Rate Crises and Fiscal Solvency," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(6), pages 1109-1135, 09.
  5. Falko Juessen & Ludger Linnemann & Andreas Schabert, 2014. "Default Risk Premia on Government Bonds in a Quantitative Macroeconomic Model," Working Paper Series in Economics 73, University of Cologne, Department of Economics.
  6. Betty C. Daniel & Christos Shiamptanis, 2009. "Fiscal Policy in the European Monetary Union," Working Papers 2009-1, Central Bank of Cyprus.
  7. Christos Shiamptanis, 2014. "Risk Assessment Under A Nonlinear Fiscal Policy Rule," LCERPA Working Papers lm0063, Laurier Centre for Economic Research and Policy Analysis, revised Jun 2014.
  8. Huixin Bi, 2010. "Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy," Caepr Working Papers 2010-007, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  9. repec:wlu:lcerpa:wm0070 is not listed on IDEAS

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