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Asset Purchases in a Monetary Union with Default and Liquidity Risks

Author

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  • Huixin Bi
  • Andrew Foerster
  • Nora Traum

Abstract

Using a two-country monetary union framework with financial frictions, we quantify the efficacy of targeted asset purchases, as well as expectations of such programs, in the presence of sovereign default and financial liquidity risks. The risk of default increases with the level of government debt and shifts in investors’ perception of fiscal solvency. Liquidity risks increase when the probability of default affects the tightness of credit markets. We calibrate the model to Italy during the 2012 European debt crisis and compare it to key features of the data. We find that changes in investors’ perception played a more significant role than increases in government debt in affecting the macroeconomy. When a debt crisis occurs, asset purchases help stabilize both financial markets and the economy. This stabilization effect can occur even if asset purchases are expected but never implemented. Moreover, expectations of potential asset purchases during a crisis alter the level of economic activity in periods when there are no crises.

Suggested Citation

  • Huixin Bi & Andrew Foerster & Nora Traum, 2025. "Asset Purchases in a Monetary Union with Default and Liquidity Risks," Working Paper Series 2025-10, Federal Reserve Bank of San Francisco.
    • Handle: RePEc:fip:fedfwp:99977
    DOI: 10.24148/wp2025-10
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    Keywords

    fiscal policy; monetary policy; unconventional monetary policy; Monetary Union; financial frictions; Regime-Switching Models;
    All these keywords.

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • F45 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Macroeconomic Issues of Monetary Unions

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