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Fiscal Risk in a Monetary Union

  • Betty Daniel
  • Christos Shiamptanis

A country entering a monetary union gives up the right to determine its own monetary policy. Individual fiscal authorities promise passive fiscal policy, allowing the central monetary authority to use active monetary policy. Since a government, which can print its own money, can honor its nominal debt unconditionally, entrance into a monetary union raises new issues of potential fiscal insolvency. When there is an upper bound on the magnitude of the surplus and stochastic shocks to the surplus, a government can find itself in a position in which it cannot borrow to continue with its desired passive fiscal policy. This paper considers the risk of a fiscal financial crisis in a monetary union under alternative assumptions about how the fiscal authority would respond. The response affects the timing and probability of a crisis. We consider both outright default and policy switching, whereby the fiscal authority in crisis switches to active fiscal policy and the monetary authority switches to passive monetary policy. We apply the model to estimate fiscal risk in the European Monetary Union. Using panel estimates of the parameters in the surplus rule and initial values for government debt and the primary surplus, we simulate fiscal risk under the two alternative fiscal responses to a crisis. We find that countries with initial values bound by the Maastricht Treaty limits are safe, while countries like Italy and Greece, in which debt has strayed far above these limits, might not be.

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File URL: http://www.albany.edu/economics/research/workingp/2008/RiskEMU12188.pdf
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Paper provided by University at Albany, SUNY, Department of Economics in its series Discussion Papers with number 08-12.

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Date of creation: 2008
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Handle: RePEc:nya:albaec:08-12
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