Discussion paper
DP16837 Fear of Hiking? Monetary Policy and Sovereign Risk
What are the implications of a monetary tightening in a currency union for sovereign default risk in a union member? We study this question in a quantitative sovereign default model and obtain two results. First, a monetary tightening reduces default risk in the union member when its debt/GDP ratio is below a critical threshold, driven by increased incentives to reduce the level of debt. Second, the monetary tightening increases default risk when debt/GDP is above the critical threshold. We quantify this "Fear of Hiking" zone and study its policy implications by applying our model to the euro area.
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