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Faculty of Economics

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Corsetti, G., Kuester, K., Meier, A. and Müller, G. J.

Sovereign risk and belief-driven fluctuations in the euro area

Journal of Monetary Economics

Vol. 61(1) pp. 53-73 (2014)

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

JEL Codes: E62, F41, F42

Author links: Giancarlo Corsetti  

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