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Asset Purchases in a Monetary Union with Default and Liquidity Risks

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  • Huixin Bi
  • Andrew Foerster
  • Nora Traum

Abstract

We develop a nonlinear two-country monetary union model with endogenous sovereign default and financial intermediation to study the effects of targeted asset purchases, and expectations of such programs, during sovereign debt crises. Default risk increases with government debt and shifts in investors’ perceptions of fiscal solvency. We calibrate the model to Italy and Germany during the 2012 European debt crisis; it reproduces key features of the data, including the periphery-core divergence in investment, output, and sovereign yields. Cross-border transmission depends on the substitutability of sovereign bonds: when bonds are poor substitutes, the crisis country contracts while the rest of the union expands, whereas highly substitutable bonds generate a synchronized downturn. During a debt crisis, asset purchases stabilize financial markets and the macroeconomy, and this stabilization can occur even if purchases are expected but never implemented. However, expectations of potential asset purchases can also distort normal-times activity by encouraging greater risk-taking.

Suggested Citation

  • Huixin Bi & Andrew Foerster & Nora Traum, 2024. "Asset Purchases in a Monetary Union with Default and Liquidity Risks," Research Working Paper RWP 24-13, Federal Reserve Bank of Kansas City, revised 03 Jul 2026.
    • Handle: RePEc:fip:fedkrw:99294
    DOI: 10.18651/RWP2024-13
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    1. Bi, Huixin, 2012. "Sovereign default risk premia, fiscal limits, and fiscal policy," European Economic Review, Elsevier, vol. 56(3), pages 389-410.
    2. Poutineau, Jean-Christophe & Vermandel, Gauthier, 2015. "Cross-border banking flows spillovers in the Eurozone: Evidence from an estimated DSGE model," Journal of Economic Dynamics and Control, Elsevier, vol. 51(C), pages 378-403.
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    Keywords

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    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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