1. Sovereign Default
in a Monetary Union
Sergio de Ferra1
Federica Romei2
1
Stockholm University
2
Stockholm School of Economics and CEPR
ADEMU Conference
April 2018
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4. Three Motivating Facts
1. Fall in key monetary policy interest rate, all the way to zero
2. Rise in sovereign default risk, and in government borrowing costs
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6. Three Motivating Facts
1. Fall in key monetary policy interest rate, all the way to zero
2. Rise in sovereign default risk, and in government borrowing costs
3. Simultaneous rise in interest rates for many euro area countries
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8. Three Motivating Facts
1. Fall in key monetary policy interest rate, all the way to zero
2. Rise in sovereign default risk, and in government borrowing costs
3. Simultaneous rise in interest rates for many euro area countries
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10. Research Questions
Does monetary policy influence default?
What if many debtors are close to default at the same time?
Does default influence monetary policy?
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11. Research Questions
Does monetary policy influence default?
What if many debtors are close to default at the same time?
How does the zero lower bound affect default risk?
Does default influence monetary policy?
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12. Research Questions
Does monetary policy influence default?
What if many debtors are close to default at the same time?
How does the zero lower bound affect default risk?
Does default influence monetary policy?
Can default risk change preferences for monetary policy?
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15. Key Results
Strong spillovers!
Monetary Policy ⇔ Default
Default induces expansionary monetary policy
More default in a monetary union
The zero lower bound enforces debt repayment
The zlb prevents expansionary monetary policy
Default causes large, unattractive fall in demand
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16. Key Results
Strong spillovers!
Monetary Policy ⇔ Default
Default induces expansionary monetary policy
More default in a monetary union
The zero lower bound enforces debt repayment
The zlb prevents expansionary monetary policy
Default causes large, unattractive fall in demand
Saving countries accept loose monetary policy
Lax monetary policy helps debtors repay
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18. Literature Review
1. Sovereign default
Explicit consideration of lenders
Nominal effects of lender-borrower interaction in monetary union
2. Monetary unions
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19. Literature Review
1. Sovereign default
Explicit consideration of lenders
Nominal effects of lender-borrower interaction in monetary union
2. Monetary unions
Does the design of a monetary union affect default incentives?
11
20. Literature Review
1. Sovereign default
Explicit consideration of lenders
Nominal effects of lender-borrower interaction in monetary union
Arellano (2008), Cole and Kehoe (2000), Hatchondo and Martinez
(2009), Hatchondo, Martinez and Sosa-Padilla (2014-2016),
Lorenzoni and Werning (2014), Na, Schmitt-Groh´e-Uribe, Yue
(2017) . . .
2. Monetary unions
Does the design of a monetary union affect default incentives?
Philippon and Martin (2017), Farhi and Werning (2017), Fornaro
(2015), Ayres, Navarro, Nicolini, Teles (2018), Corsetti, Kuester,
Meier, Mueller (2013) Corsetti and Dedola (2016) . . .
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22. The Model - Environment
The economy lasts for two periods
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23. The Model - Environment
The economy lasts for two periods
The world is composed of a continuum of small open economies
Two (groups of) countries: Home, Foreign
Countries share currency in a monetary union
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24. The Model - Environment
The economy lasts for two periods
The world is composed of a continuum of small open economies
Two (groups of) countries: Home, Foreign
Countries share currency in a monetary union
Each country inhabited by households, firms, fiscal authority
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25. The Model - Environment
The economy lasts for two periods
The world is composed of a continuum of small open economies
Two (groups of) countries: Home, Foreign
Countries share currency in a monetary union
Each country inhabited by households, firms, fiscal authority
Two types of goods, Tradable, Non-Tradable
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26. The Model - Environment
The economy lasts for two periods
The world is composed of a continuum of small open economies
Two (groups of) countries: Home, Foreign
Countries share currency in a monetary union
Each country inhabited by households, firms, fiscal authority
Two types of goods, Tradable, Non-Tradable
N-good produced by firms in each country
T-good endowment has a skewed profile
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27. The Model - Environment
The economy lasts for two periods
The world is composed of a continuum of small open economies
Two (groups of) countries: Home, Foreign
Countries share currency in a monetary union
Each country inhabited by households, firms, fiscal authority
Two types of goods, Tradable, Non-Tradable
N-good produced by firms in each country
T-good endowment has a skewed profile
Default risk is key source of uncertainty
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28. The Model - Autarky Endowments
yT,2
yT,1yL yH
yL
yH Home
Foreign
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29. The Model - Households
Preferences
Ui = log ca
T,i,1c1−a
N,i,1 + βE log ca
T,i,2c1−a
N,i,2
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30. The Model - Households
Preferences
Ui = log ca
T,i,1c1−a
N,i,1 + βE log ca
T,i,2c1−a
N,i,2
Households supply labor inelastically
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31. The Model - Households
Preferences
Ui = log ca
T,i,1c1−a
N,i,1 + βE log ca
T,i,2c1−a
N,i,2
Households supply labor inelastically
Resources
Receive endowment of T-good, labour income, fiscal transfers
Purchase two consumption goods, nominal assets eq’s .
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32. The Model - Households
Relative demand for N and T goods
cN,i,t =
1 − a
a
pT,t
pN,i,t
cT,i,t
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33. The Model - Households
Relative demand for N and T goods
cN,i,t =
1 − a
a
pT,t
pN,i,t
cT,i,t
Price index of consumption basket
pi,t = pa
T,t × p1−a
N,i,t
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34. The Model - Households
Relative demand for N and T goods
cN,i,t =
1 − a
a
pT,t
pN,i,t
cT,i,t
Price index of consumption basket
pi,t = pa
T,t × p1−a
N,i,t
Demand for nominal assets
1
cT,i,1
= β (1 + i) E
pT,1
pT,2
1
cT,i,2
+ µi,j
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36. Firms and Nominal Rigidities
Competitive firms produce good N:
max
yN,i,li
pN,iyN,i−wili
subject to technology: yN,i = li
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37. Firms and Nominal Rigidities
Competitive firms produce good N:
max
yN,i,li
pN,iyN,i−wili
subject to technology: yN,i = li
In equilibrium: pN,i = wi.
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38. Firms and Nominal Rigidities
Competitive firms produce good N:
max
yN,i,li
pN,iyN,i−wili
subject to technology: yN,i = li
In equilibrium: pN,i = wi.
Downward wage rigidities:
wi,1 ≥ κ
wi,2 ≥ κwi,1
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39. Monetary Policy Authority
Objective to maintain price stability in the monetary union
p∗
1 = exp
1
0
ψi × log(pi,1)di
π∗
= exp
1
0
ψi × log(πi,2)di ,
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40. Monetary Policy Authority
Objective to maintain price stability in the monetary union
p∗
1 = exp
1
0
ψi × log(pi,1)di
π∗
= exp
1
0
ψi × log(πi,2)di ,
The nominal interest rate is the key policy instrument
i ≥ 0
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43. Fiscal Authority
In each country, the fiscal authority takes two key decisions:
1. Default
At t = 1
At t = 2
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44. Fiscal Authority
In each country, the fiscal authority takes two key decisions:
1. Default
At t = 1
At t = 2
2. Borrowing and Saving
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45. Fiscal Authority
In each country, the fiscal authority takes two key decisions:
1. Default
At t = 1
At t = 2
2. Borrowing and Saving
Objective to maximize household welfare
Rebates resources via fiscal transfers
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46. Fiscal Authority
In each country, the fiscal authority takes two key decisions:
1. Default
At t = 1
At t = 2
2. Borrowing and Saving
Objective to maximize household welfare
Rebates resources via fiscal transfers
Will analyze fiscal authority’s decisions backwards
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47. Default at t = 2
Stochastic default cost ζ2:
ζ2 =
ˆζ > 0 with probability ω,
0 with probability 1 − ω.
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48. Default at t = 2
Stochastic default cost ζ2:
ζ2 =
ˆζ > 0 with probability ω,
0 with probability 1 − ω.
Default on debt with probability 1 − ω:
Default ⇔ −bi,2 > ζ2
Repay with probability ω
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49. Default at t = 2
Stochastic default cost ζ2:
ζ2 =
ˆζ > 0 with probability ω,
0 with probability 1 − ω.
Default on debt with probability 1 − ω:
Default ⇔ −bi,2 > ζ2
Repay with probability ω
The cost of repaying or defaulting is rebated to households
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50. Borrowing and Saving at t = 1
Ex-ante heterogeneity in initial assets
Debt in H: bH,1 < 0
Assets in F: bF,1 > 0
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51. Borrowing and Saving at t = 1
Ex-ante heterogeneity in initial assets
Debt in H: bH,1 < 0
Assets in F: bF,1 > 0
Fiscal authorities trade assets bi,2 with interest rate ri
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52. Borrowing and Saving at t = 1
Ex-ante heterogeneity in initial assets
Debt in H: bH,1 < 0
Assets in F: bF,1 > 0
Fiscal authorities trade assets bi,2 with interest rate ri
Government budget constraint:
si,1 = bi,1 −
1
1 + ri
bi,2.
Euler equation
1
cT,i,1
= βω (1 + ri)
1
cT,i,2
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53. Default at t = 1
Penalty for default
Exclusion from financial markets ⇒ autarky.
Default cost ζ1
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54. Default at t = 1
Penalty for default
Exclusion from financial markets ⇒ autarky.
Default cost ζ1
Benevolent default decision
Default ⇔ VD > VR (bH,1)
VR and VD are the household values upon default and repayment
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55. Default at t = 1
Penalty for default
Exclusion from financial markets ⇒ autarky.
Default cost ζ1
Benevolent default decision
Default ⇔ VD > VR (bH,1)
VR and VD are the household values upon default and repayment
Default threshold
¯b ⇔ VD = VR
¯b
At ¯b, indifference between repayment and default
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67. Simplest Sovereign Default
Ignore for a second nominal rigidities
Consumption under Default
cT,D,1 = yL − ζ1, cT,D,2 = yH − ζ2
Consumption under Repay
cT,R,1 = cT,R,2 = cT,R (bH,1)
Default Threshold
VR
¯b = VD
What would be the impact of nominal rigidities on default?
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68. Demand and Nominal Rigidities
Demand for good N
cN =
1 − a
a
pT
pN
cT
Nominal rigidity
(yN − l) (pN − κ) = 0
Equilibrium
cN = yN
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69. Demand and Nominal Rigidities
pN
pT
cN
cN = 1−a
a
pT
pN
cT
l
κ
pT
cN = yN
Unemployment
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71. Nominal Rigidities and Default
Repaying debt causes low current cT
Low demand causes low output
cN =
1 − a
a
pT
pN
cT
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72. A Fall in cT
pN
pT
cN
κ
pT
cT ↓
Unemployment
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73. Nominal Rigidities and Default
Repaying debt causes low current cT
Low demand causes low output
cN =
1 − a
a
pT
pN
cT
Repaying debt becomes less attractive
Fall in default threshold
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81. Default in the Monetary Union
What if all countries in H are close to default?
What implications of default for prices and monetary policy?
pT ↑, i ↓
Default causes expansionary monetary policy
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82. Default in the Monetary Union
What if all countries in H are close to default?
What implications of default for prices and monetary policy?
pT ↑, i ↓
Default causes expansionary monetary policy
What implications for demand and output?
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84. A Rise in pT
pN
pT
cN
κ
pT
pT ↑
Unemployment
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85. Default in the Monetary Union
What if all countries in H are close to default?
What implications of default for prices and monetary policy?
pT ↑, i ↓
Default causes expansionary monetary policy
What implications for demand and output?
cN,H ↑, yN,H ↑
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86. Default in the Monetary Union
What if all countries in H are close to default?
What implications of default for prices and monetary policy?
pT ↑, i ↓
Default causes expansionary monetary policy
What implications for demand and output?
cN,H ↑, yN,H ↑
What implications for optimal default?
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88. Default in the Monetary Union
c2
c1cD,1
cD,2
Default
cT,R (bH,1)
cR
¯b
New Def’t Thr.
cD,2
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89. Default in the Monetary Union
What if all countries in H are close to default?
What implications of default for prices and monetary policy?
pT ↑, i ↓
Default causes expansionary monetary policy
What implications for demand and output?
cN,H ↑, yN,H ↑
What implications for optimal default?
Default is more attractive
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90. Default at the Zero Lower Bound
What if the ZLB prevents expansionary monetary policy?
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93. Default at the Zero Lower Bound
What if the ZLB prevents expansionary monetary policy?
ZLB causes equilibrium pT to be lower
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94. Default at the Zero Lower Bound
What if the ZLB prevents expansionary monetary policy?
ZLB causes equilibrium pT to be lower
Fall in pT may be larger upon default
50
96. Default at the Zero Lower Bound
What if the ZLB prevents expansionary monetary policy?
ZLB causes equilibrium pT to be lower
Fall in pT may be larger upon default
Default causes large fall in natural interest rate
For savers, fall in asset supply and wealth
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97. Default at the Zero Lower Bound
What if the ZLB prevents expansionary monetary policy?
ZLB causes equilibrium pT to be lower
Fall in pT may be larger upon default
Default causes large fall in natural interest rate
For savers, fall in asset supply and wealth
ZLB induces debtors to repay
Low pT makes default unattractive
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101. Preferences over Monetary Policy
Countries in H are doves
They want expansionary policy, a high target p∗
1
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102. Preferences over Monetary Policy
Countries in H are doves
They want expansionary policy, a high target p∗
1
Countries in F are hawks
They want contractionary policy, a low target p∗
1
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103. Preferences over Monetary Policy
Countries in H are doves
They want expansionary policy, a high target p∗
1
Countries in F are hawks
They want contractionary policy, a low target p∗
1
H welfare is increasing in p∗
1
p∗
1 ↑ ⇒ pT,1 ↑ ⇒ cN,H,1 ↑
F welfare is less obvious. . .
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104. Preferences over Monetary Policy - F
Initial-period monetary relaxation implies terminal-period
tightening
p∗
1 ↑ ⇒ πT,2 ↓
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105. Preferences over Monetary Policy - F
Initial-period monetary relaxation implies terminal-period
tightening
p∗
1 ↑ ⇒ πT,2 ↓
Prices in H adjust sluggishly
Terminal-period inflation would rise
Monetary authority contracts policy to meet target π∗
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106. Preferences over Monetary Policy - F
Initial-period monetary relaxation implies terminal-period
tightening
p∗
1 ↑ ⇒ πT,2 ↓
Prices in H adjust sluggishly
Terminal-period inflation would rise
Monetary authority contracts policy to meet target π∗
F welfare is increasing in πT,2
cN,F,2 ↓ =
πT,2 ↓
κ
cT,F,2
cT,F,1
l
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107. Preferences over Monetary Policy - F
Initial-period monetary relaxation implies terminal-period
tightening
p∗
1 ↑ ⇒ πT,2 ↓
Prices in H adjust sluggishly
Terminal-period inflation would rise
Monetary authority contracts policy to meet target π∗
F welfare is increasing in πT,2
cN,F,2 ↓ =
πT,2 ↓
κ
cT,F,2
cT,F,1
l
F welfare is decreasing in p∗
1
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109. Monetary Policy Preferences and
Default
Can the threat of default milden savers’ hawkish tendencies?
Suppose that H just about prefers to default
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110. Monetary Policy Preferences and
Default
Can the threat of default milden savers’ hawkish tendencies?
Suppose that H just about prefers to default
A higher p∗
1 would induce H to repay
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113. Monetary Policy Preferences and
Default
Can the threat of default milden savers’ hawkish tendencies?
Suppose that H just about prefers to default
A higher p∗
1 would induce H to repay
F agrees with H, and both support expansionary policy
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114. Monetary Policy Preferences and
Default
Can the threat of default milden savers’ hawkish tendencies?
Suppose that H just about prefers to default
A higher p∗
1 would induce H to repay
F agrees with H, and both support expansionary policy
H is happy since unemployment falls
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115. Monetary Policy Preferences and
Default
Can the threat of default milden savers’ hawkish tendencies?
Suppose that H just about prefers to default
A higher p∗
1 would induce H to repay
F agrees with H, and both support expansionary policy
H is happy since unemployment falls
F is happy because debt gets repaid
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116. Concluding Remarks
Simple model delivers three key results. . .
Default by many countries induces expansionary monetary policy
Zero lower bound induces debtors to repay
Default broadens support for expansionary monetary policy
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117. Concluding Remarks
Simple model delivers three key results. . .
Default by many countries induces expansionary monetary policy
Zero lower bound induces debtors to repay
Default broadens support for expansionary monetary policy
. . . that are close to euro-area experience
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118. Concluding Remarks
Simple model delivers three key results. . .
Default by many countries induces expansionary monetary policy
Zero lower bound induces debtors to repay
Default broadens support for expansionary monetary policy
. . . that are close to euro-area experience
Use these insights to build infinite-horizon model
Dynamics of debt accumulation in a monetary union
Slow deleveraging in a debt crisis
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