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Sovereign Default Risk in a Monetary Union

  • Betty C. Daniel

    ()

    (University at Albany)

  • Christos Shiamptanis

    ()

    (Central Bank of Cyprus)

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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File URL: http://www.centralbank.gov.cy/media/pdf/NPWPE_No3_052010.pdf
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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
Contact details of provider: Web page: http://www.centralbank.gov.cy/nqcontent.cfm?a_id=1

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  1. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Proceedings, Federal Reserve Bank of Cleveland, pages 519-546.
  2. Jonathan Heathcote & Cristina Arellano, 2004. "Dollarization and Financial Integration," 2004 Meeting Papers 10, Society for Economic Dynamics.
  3. Daniel, Betty C, 2001. "A Fiscal Theory of Currency Crises," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(4), pages 969-88, November.
  4. Harold L. Cole & Timothy J. Kehoe, 1998. "Self-fulfilling debt crises," Staff Report 211, Federal Reserve Bank of Minneapolis.
  5. Evan Tanner & Issouf Samaké, 2006. "Probabilistic Sustainability of Public Debt; A Vector Autoregression Approach for Brazil, Mexico, and Turkey," IMF Working Papers 06/295, International Monetary Fund.
  6. Márcio Gomes Pinto Garcia & Roberto Rigobon, 2004. "A Risk Management Approach to Emerging Market’s Sovereign Debt Sustainability with an Application to Brazilian Data," Textos para discussão 484, Department of Economics PUC-Rio (Brazil).
  7. 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.
  8. Yue, Vivian Z., 2010. "Sovereign default and debt renegotiation," Journal of International Economics, Elsevier, vol. 80(2), pages 176-187, March.
  9. Cooper, R. & Kempf, H. & Peled, D., 2007. "Regional Debt in Monetary Unions: Is it Inflationary?," Working papers 186, Banque de France.
  10. Bernheim, B Douglas, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 540-42, August.
  11. 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.
  12. John H. Cochrane, 1999. "A Frictionless View of U.S. Inflation," NBER Chapters, in: NBER Macroeconomics Annual 1998, volume 13, pages 323-421 National Bureau of Economic Research, Inc.
  13. Betty Daniel, 2008. "Exchange Rate Crises and Fiscal Solvency," Discussion Papers 08-09, University at Albany, SUNY, Department of Economics.
  14. Harold L. Cole & Timothy J. Kehoe, 1996. "A self-fulfilling model of Mexico's 1994-95 debt crisis," Staff Report 210, Federal Reserve Bank of Minneapolis.
  15. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, vol. 4(3), pages 345-80.
  16. Henning Bohn, 1998. "The Behavior Of U.S. Public Debt And Deficits," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 949-963, August.
  17. Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 1998. "Is the Price Level Determined by the Needs of Fiscal Solvency?," NBER Working Papers 6471, National Bureau of Economic Research, Inc.
  18. 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.
  19. Betty Daniel & Christos Shiamptanis, 2008. "Fiscal Policy in the European Monetary Union," Discussion Papers 08-11, University at Albany, SUNY, Department of Economics.
  20. Troy Davig & Eric M. Leeper & Todd B. Walker, 2010. ""Unfunded Liabilities" and Uncertain Fiscal Financing," NBER Working Papers 15782, National Bureau of Economic Research, Inc.
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  23. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
  24. 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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