DP12976 Sovereign Default in a Monetary Union
We introduce a framework to analyze a monetary union where countries run independent fiscal policies and can default on their sovereign debt. In this environment, we show that debtors’ default is deflationary and leads to expansionary monetary policy in the union as a whole. An expansionary monetary policy, in turn, makes defaulting more appealing for debtors. Default also lowers equilibrium risk-free interest rates. If there is a lower bound on the nominal interest rate, default leads to a larger output loss in debtor countries. Hence, a lower bound on interest rates makes default less appealing and debt repayment more appealing. To quantify the importance of these channels, we develop a rich, calibrated model with heterogeneous countries, long-term debt, nominal rigidities and endogenous default. We find that defaulting has significant effects on inflation and nominal interest rates within the monetary union. This framework helps explain the attention of monetary authorities in the euro area to fiscal policy sustainability in member countries.