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Sovereign Risk and Belief-Driven Fluctuations in the Euro Area

  • Giancarlo Corsetti
  • Keith Kuester
  • André Meier
  • Gernot J. Mueller

Sovereign risk premia in several euro area countries have risen markedly since 2008, driving up credit spreads in the private sector as well. We propose a New Keynesian model of a two-region monetary union that accounts for this “sovereign risk channel.” The model is calibrated to the euro area as of mid-2012. We show that a combination of sovereign risk in one region and strongly procyclical fiscal policy at the aggregate level exacerbates the risk of belief-driven deflationary downturns. The model provides an argument in favor of coordinated, asymmetric fiscal stances as a way to prevent selffulfilling debt crises.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 13/227.

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Length: 49
Date of creation: 06 Nov 2013
Date of revision:
Handle: RePEc:imf:imfwpa:13/227
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  1. repec:dgr:uvatin:20110064 is not listed on IDEAS
  2. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
  3. Vasco Curdia & Michael Woodford, 2008. "Credit Frictions and Optimal Monetary Policy," Discussion Papers 0809-02, Columbia University, Department of Economics.
  4. Eduardo A. Cavallo & Patricio Valenzuela, 2007. "The Determinants of Corporate Risk in Emerging Markets: An Option-Adjusted Spread Analysis," IMF Working Papers 07/228, International Monetary Fund.
  5. Serkan Arslanalp & Yin Liao, 2013. "Contingent Liabilities and Sovereign Risk: Evidence from Banking Sectors," CAMA Working Papers 2013-43, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  6. Philip R. Lane, 2012. "The European Sovereign Debt Crisis," Journal of Economic Perspectives, American Economic Association, vol. 26(3), pages 49-68, Summer.
  7. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  8. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  9. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  10. Robert Kollmann & Werner Roeger & Jan in't Veld, 2012. "Fiscal Policy in a Financial Crisis: Standard Policy versus Bank Rescue Measures," American Economic Review, American Economic Association, vol. 102(3), pages 77-81, May.
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