Working Paper: CEPR ID: DP10817
Authors: Alexander Kriwoluzky; Gernot Müller; Martin Wolf
Abstract: Membership in a currency union is not irreversible. Expectations of exit may emerge during a sovereign debt crisis, because by exiting countries can redenominate and reduce their liabilities. This possibility alters the dynamics of sovereign debt crises. We establish this formally within a small open economy model of changing policy regimes. The model permits explosive dynamics of debt and sovereign yields inside the currency union and allows us to distinguish between exit expectations and those of an outright default. By estimating the model on Greek data, we quantify the contribution of exit expectations to the crisis dynamics during 2009-2012.
Keywords: currency union; euro crisis; exit; fiscal policy; redenomination premium; regime switching model; sovereign debt crisis
JEL Codes: E41; E52; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase sovereign yields (H63) | rise in perceived risk associated with holding government bonds (E43) |
| higher public debt (H69) | increase exit expectations (D84) |
| increase exit expectations (D84) | higher public debt (H69) |
| rising interest rates (E43) | reduced economic activity (F69) |
| higher exit expectations (I21) | increase sovereign yields (H63) |
| higher exit expectations (I21) | stagflationary effects on the economy (E31) |