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Sovereign Default Risk in a Monetary Union

Author

Listed:
  • 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.

Suggested Citation

  • Betty C. Daniel & Christos Shiamptanis, 2010. "Sovereign Default Risk in a Monetary Union," Working Papers 2010-3, Central Bank of Cyprus.
  • Handle: RePEc:cyb:wpaper:2010-3
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    File URL: http://www.centralbank.gov.cy/media/pdf/NPWPE_No3_052010.pdf
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    References listed on IDEAS

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    1. Eaton, Jonathan & Fernandez, Raquel, 1995. "Sovereign debt," Handbook of International Economics,in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 3, pages 2031-2077 Elsevier.
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    Cited by:

    1. Carolina Achury & Christos Koulovatianos & John Tsoukalas, "undated". "External Sovereign Debt in a Monetary Union: Bailouts and the Role of Corruption," Discussion Papers 11/11, University of Nottingham, Centre for Finance, Credit and Macroeconomics (CFCM).
    2. Gros, Daniel, 2012. "A simple model of multiple equilibria and sovereign default," CEPS Papers 7174, Centre for European Policy Studies.
    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.
    4. COMBEY, Adama & NUBUKPO, Kako, 2013. "Coordination des Politiques Economiques au Sein de la Zone UEMOA : Bilan et Perspectives
      [Economic Policy Coordination in the WAEMU: Results and Prospects]
      ," MPRA Paper 58118, University Library of Munich, Germany, revised Aug 2014.

    More about this item

    Keywords

    European Monetary Union; sovereign default; financial crisis;

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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