Year: 2014
Type: report
Abstract: We characterize fiscal and monetary policy in a monetary union with the potential for rollover crises in sovereign debt markets.Member-country fiscal authorities lack commitment to repay their debt and choose fiscal policy independently.A common monetary authority chooses inflation for the union, also without commitment.We first describe the existence of a fiscal externality that arises in the presence of limited commitment and leads countries to over borrow; this externality rationalizes the imposition of debt ceilings in a monetary union.We then investigate the impact of the composition of debt in a monetary union, that is the fraction of high-debt versus low-debt members, on the occurrence of self-fulfilling debt crises.We demonstrate that a high-debt country may be less vulnerable to crises and have higher welfare when it belongs to a union with an intermediate mix of high-and low-debt members, than one where all other members are low-debt.This contrasts with the conventional wisdom that all countries should prefer a union with low-debt members, as such a union can credibly deliver low inflation.These findings shed new light on the criteria for an optimal currency area in the presence of rollover crises.
DOI: 10.3386/w20277
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: green
Funder: National Science Foundation
OpenAlex ID: W3125965835