Wednesday, November 6, 2013

Sovereign Risk and Belief-Driven Fluctuations in the Euro Area

by Giancarlo Corsetti, Keith Kuester, André Meier & Gernot J. Mueller

International Monetary Fund

November 6, 2013
Working Paper No. 13/227

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.

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