DP9723 Sovereign risk and belief-driven fluctuations in the euro area

Author(s):	Giancarlo Corsetti, Keith Kuester, André Meier, Gernot Müller
Publication Date:	November 2013
Keyword(s):	euro area, monetary union, pooling of sovereign risk, risk premium, sovereign risk channel, zero lower bound
JEL(s):	E62, F41, F42
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=9723

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.