Working Paper: CEPR ID: DP9723
Authors: Giancarlo Corsetti; Keith Kuester; Andr Meier; Gernot Müller
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: euro area; monetary union; pooling of sovereign risk; risk premium; sovereign risk channel; zero lower bound
JEL Codes: E62; F41; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased sovereign risk premia in one region of the euro area (F34) | higher credit spreads in the private sector (G19) |
| higher credit spreads in the private sector (G19) | depresses economic activity (E32) |
| sovereign debt crisis exacerbates equilibrium indeterminacy within the currency union (F65) | belief-driven deflationary downturns (E32) |
| negative expectations (D84) | further economic decline (N16) |
| coordinated asymmetric fiscal stances (F42) | stabilize the economy (E63) |