Sovereign Risk and Belief-Driven Fluctuations in the Euro Area

Author/Editor: Giancarlo Corsetti ; Keith Kuester ; André Meier ; Gernot J. Mueller
Publication Date: November 06, 2013
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate
Summary: 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.
Series: Working Paper No. 13/227
Subject(s): Sovereign debt | Euro Area | Fiscal risk | Risk premium | Fiscal policy | Monetary policy | Economic models

Publication Date: November 06, 2013
ISBN/ISSN: 9781475513448/1018-5941 Format: Paper
Stock No: WPIEA2013227 Pages: 49
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