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Sovereign risk and belief-driven fluctuations in the euro area
Affiliation:1. Cambridge University, United Kingdom;2. CEPR, United Kingdom;3. University of Bonn, Germany;4. International Monetary Fund, United States;1. Paris School of Economics, University of Paris 1 Panthéon-Sorbonne, and CEPR, France;2. Australian National University, CAMA, and EABCN, Australia;3. University .of Washington, CEPR, EABCN, and NBER, United States;1. New York University, 40 Washington Square South, New York, NY 10012, United States;2. Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue N.W., Washington, D.C. 20551, United States;1. Sao Paulo School of Economics-FGV, Brazil;2. Michigan State University, United States;1. London Business School, Regent׳s Park, London NW1 4SA, United Kingdom;2. Department of Economics, University of Leicester, Leicester LE1 7RH, United Kingdom;1. Department of Economics, University of North Carolina at Chapel Hill, 6C Gardner Hall, CB 3305, Chapel Hill, NC 27599-3305, United States;2. Department of Economics, Arizona State University, W.P. Carey School of Business, 501 E. Orange Street, Tempe, AZ 85287, United States
Abstract: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 self-fulfilling debt crises.
Keywords:Sovereign risk channel  Monetary union  Euro area  Zero lower bound  Risk premium  Pooling of sovereign risk
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