DP10817 Exit expectations and debt crises in currency unions

Author(s): Alexander Kriwoluzky, Gernot Müller, Martin Wolf
Publication Date: September 2015
Keyword(s): currency union, euro crisis, exit, fiscal policy, redenomination premium, regime-switching model, sovereign debt crisis
JEL(s): E41, E52, E62
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10817

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.