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Sovereign default in a monetary union

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The document discusses sovereign default in a monetary union. It presents three motivating facts: (1) key interest rates falling to zero, (2) rising sovereign default risk and government borrowing costs, and (3) simultaneous increases in interest rates across euro area countries. The research questions examine how monetary policy and sovereign default influence each other. Key results show strong spillover effects between monetary policy and default. Default induces expansionary monetary policy and more default occurs in a monetary union. The zero lower bound prevents expansionary monetary policy and default causes large declines in demand.

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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 1
Three Motivating Facts 1. Fall in key monetary policy interest rate, all the way to zero 2
ECB Policy Rate 3
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 4
Interest Rate in Greece 5
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 6
Interest Rates in the Euro Area 7
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 8
Research Questions Does monetary policy influence default? Does default influence monetary policy? 9
Research Questions Does monetary policy influence default? What if many debtors are close to default at the same time? Does default influence monetary policy? 9
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? 9
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? 9
Key Results Strong spillovers! Monetary Policy ⇔ Default 10
Key Results Strong spillovers! Monetary Policy ⇔ Default Default induces expansionary monetary policy More default in a monetary union 10
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 10
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 10
Literature Review 1. Sovereign default 2. Monetary unions 11
Literature Review 1. Sovereign default Explicit consideration of lenders Nominal effects of lender-borrower interaction in monetary union 2. Monetary unions 11
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
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) . . . 11
Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 12
The Model - Environment The economy lasts for two periods 13
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 13
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 13
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 13
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 13
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 13
The Model - Autarky Endowments yT,2 yT,1yL yH yL yH Home Foreign 14
The Model - Households Preferences Ui = log ca T,i,1c1−a N,i,1 + βE log ca T,i,2c1−a N,i,2 15
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 15
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 . 15
The Model - Households Relative demand for N and T goods cN,i,t = 1 − a a pT,t pN,i,t cT,i,t 16
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 16
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 16
Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 17
Firms and Nominal Rigidities Competitive firms produce good N: max yN,i,li pN,iyN,i−wili subject to technology: yN,i = li 18
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. 18
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 18
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 , 19
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 19
Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 20
Fiscal Authority In each country, the fiscal authority takes two key decisions: 21
Fiscal Authority In each country, the fiscal authority takes two key decisions: 1. Default At t = 1 At t = 2 21
Fiscal Authority In each country, the fiscal authority takes two key decisions: 1. Default At t = 1 At t = 2 2. Borrowing and Saving 21
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 21
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 21
Default at t = 2 Stochastic default cost ζ2: ζ2 = ˆζ > 0 with probability ω, 0 with probability 1 − ω. 22
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 22
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 22
Borrowing and Saving at t = 1 Ex-ante heterogeneity in initial assets Debt in H: bH,1 < 0 Assets in F: bF,1 > 0 23
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 23
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 23
Default at t = 1 Penalty for default Exclusion from financial markets ⇒ autarky. Default cost ζ1 24
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 24
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 24
Equilibrium Optimal choices by households, firms, fiscal authorities 25
Equilibrium Optimal choices by households, firms, fiscal authorities Target of the monetary policy 25
Equilibrium Optimal choices by households, firms, fiscal authorities Target of the monetary policy Market clearing Goods cT,H + cT,F + D · ζ = yT,H + yT,F cN,i = yN,i 25
Equilibrium Optimal choices by households, firms, fiscal authorities Target of the monetary policy Market clearing Goods cT,H + cT,F + D · ζ = yT,H + yT,F cN,i = yN,i Bonds bH,2 + bF,2 = 0 bM,H + bM,F = 0 25
Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 26
Simplest Sovereign Default Ignore for a second nominal rigidities Consumption under Default cT,D,1 = yL − ζ1, cT,D,2 = yH − ζ2 27
Simplest Sovereign Default c2 c1cD,1 cD,2 Default 28
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) 29
Simplest Sovereign Default c2 c1cD,1 cD,2 Default cT,R (bH,1) 45◦ 30
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 31
Simplest Sovereign Default c2 c1cD,1 cD,2 Default cT,R (bH,1) Default Threshold cR ¯bcD,2 32
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? 33
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 34
Demand and Nominal Rigidities pN pT cN cN = 1−a a pT pN cT l κ pT cN = yN Unemployment 35
Nominal Rigidities and Default Repaying debt causes low current cT 36
Nominal Rigidities and Default Repaying debt causes low current cT Low demand causes low output cN = 1 − a a pT pN cT 36
A Fall in cT pN pT cN κ pT cT ↓ Unemployment 37
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 38
Nominal Rigidities and Default c2 c1cD,1 cD,2 Default 39
Nominal Rigidities and Default c2 c1cD,1 cD,2 Default cT,R (bH,1) cR ¯b New Default Threshold cD,2 39
Default in the Monetary Union What if all countries in H are close to default? 40
Default in the Monetary Union What if all countries in H are close to default? What implications of default for prices and monetary policy? 40
Equilibrium in the Monetary Union 41
Equilibrium in the Monetary Union 41
Equilibrium in the Monetary Union 41
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 42
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? 42
A Rise in pT pN pT cN κ pT Unemployment 43
A Rise in pT pN pT cN κ pT pT ↑ Unemployment 43
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 ↑ 44
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? 44
Default in the Monetary Union c2 c1cD,1 cD,2 Default 45
Default in the Monetary Union c2 c1cD,1 cD,2 Default cT,R (bH,1) cR ¯b New Def’t Thr. cD,2 45
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 46
Default at the Zero Lower Bound What if the ZLB prevents expansionary monetary policy? 47
ZLB Equilibrium - Repay 48
ZLB Equilibrium - Default 49
Default at the Zero Lower Bound What if the ZLB prevents expansionary monetary policy? ZLB causes equilibrium pT to be lower 50
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
ZLB Equilibrium 51
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 52
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 52
Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 53
Preferences over Monetary Policy How would countries want Monetary Policy to be run? 54
Preferences over Monetary Policy How would countries want Monetary Policy to be run? 54
Preferences over Monetary Policy Countries in H are doves They want expansionary policy, a high target p∗ 1 55
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 55
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. . . 55
Preferences over Monetary Policy - F Initial-period monetary relaxation implies terminal-period tightening p∗ 1 ↑ ⇒ πT,2 ↓ 56
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∗ 56
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 56
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 56
Monetary Policy Preferences and Default Can the threat of default milden savers’ hawkish tendencies? 57
Monetary Policy Preferences and Default Can the threat of default milden savers’ hawkish tendencies? Suppose that H just about prefers to default 57
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 57
Monetary Policy Preferences and Default c2 c1cD,1 cD,2 Default cT,R (bH,1) cD,2 cR ¯b 58
Monetary Policy Preferences and Default c2 c1cD,1 cD,2 Default cT,R (bH,1) cD,2 cR ¯b p∗ 1 ↑ 58
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 59
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 59
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 59
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 60
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 60
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 60
Thanks! 61
Households - Appendix Budget constraints pT,1cT,i,1 + pN,i,1cN,i,1 + bM,i 1 + i = pT,1 (yT,i,1 + si,1) + wi,1li,1 pT,2cT,i,2 + pN,i,2cN,i,2 = pT,2 (yT,i,2 + si,2) + bM,i + wi,2li,2 Households 62

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Sovereign default in a monetary union

  • 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 1
  • 2. Three Motivating Facts 1. Fall in key monetary policy interest rate, all the way to zero 2
  • 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 4
  • 5. Interest Rate in Greece 5
  • 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 6
  • 7. Interest Rates in the Euro Area 7
  • 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 8
  • 9. Research Questions Does monetary policy influence default? Does default influence monetary policy? 9
  • 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? 9
  • 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? 9
  • 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? 9
  • 14. Key Results Strong spillovers! Monetary Policy ⇔ Default Default induces expansionary monetary policy More default in a monetary union 10
  • 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 10
  • 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 10
  • 17. Literature Review 1. Sovereign default 2. Monetary unions 11
  • 18. Literature Review 1. Sovereign default Explicit consideration of lenders Nominal effects of lender-borrower interaction in monetary union 2. Monetary unions 11
  • 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) . . . 11
  • 21. Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 12
  • 22. The Model - Environment The economy lasts for two periods 13
  • 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 13
  • 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 13
  • 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 13
  • 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 13
  • 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 13
  • 28. The Model - Autarky Endowments yT,2 yT,1yL yH yL yH Home Foreign 14
  • 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 15
  • 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 15
  • 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 . 15
  • 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 16
  • 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 16
  • 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 16
  • 35. Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 17
  • 36. Firms and Nominal Rigidities Competitive firms produce good N: max yN,i,li pN,iyN,i−wili subject to technology: yN,i = li 18
  • 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. 18
  • 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 18
  • 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 , 19
  • 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 19
  • 41. Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 20
  • 42. Fiscal Authority In each country, the fiscal authority takes two key decisions: 21
  • 43. Fiscal Authority In each country, the fiscal authority takes two key decisions: 1. Default At t = 1 At t = 2 21
  • 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 21
  • 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 21
  • 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 21
  • 47. Default at t = 2 Stochastic default cost ζ2: ζ2 = ˆζ > 0 with probability ω, 0 with probability 1 − ω. 22
  • 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 22
  • 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 22
  • 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 23
  • 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 23
  • 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 23
  • 53. Default at t = 1 Penalty for default Exclusion from financial markets ⇒ autarky. Default cost ζ1 24
  • 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 24
  • 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 24
  • 56. Equilibrium Optimal choices by households, firms, fiscal authorities 25
  • 57. Equilibrium Optimal choices by households, firms, fiscal authorities Target of the monetary policy 25
  • 58. Equilibrium Optimal choices by households, firms, fiscal authorities Target of the monetary policy Market clearing Goods cT,H + cT,F + D · ζ = yT,H + yT,F cN,i = yN,i 25
  • 59. Equilibrium Optimal choices by households, firms, fiscal authorities Target of the monetary policy Market clearing Goods cT,H + cT,F + D · ζ = yT,H + yT,F cN,i = yN,i Bonds bH,2 + bF,2 = 0 bM,H + bM,F = 0 25
  • 60. Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 26
  • 61. Simplest Sovereign Default Ignore for a second nominal rigidities Consumption under Default cT,D,1 = yL − ζ1, cT,D,2 = yH − ζ2 27
  • 63. 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) 29
  • 65. 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 31
  • 66. Simplest Sovereign Default c2 c1cD,1 cD,2 Default cT,R (bH,1) Default Threshold cR ¯bcD,2 32
  • 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? 33
  • 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 34
  • 69. Demand and Nominal Rigidities pN pT cN cN = 1−a a pT pN cT l κ pT cN = yN Unemployment 35
  • 70. Nominal Rigidities and Default Repaying debt causes low current cT 36
  • 71. Nominal Rigidities and Default Repaying debt causes low current cT Low demand causes low output cN = 1 − a a pT pN cT 36
  • 72. A Fall in cT pN pT cN κ pT cT ↓ Unemployment 37
  • 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 38
  • 74. Nominal Rigidities and Default c2 c1cD,1 cD,2 Default 39
  • 75. Nominal Rigidities and Default c2 c1cD,1 cD,2 Default cT,R (bH,1) cR ¯b New Default Threshold cD,2 39
  • 76. Default in the Monetary Union What if all countries in H are close to default? 40
  • 77. Default in the Monetary Union What if all countries in H are close to default? What implications of default for prices and monetary policy? 40
  • 78. Equilibrium in the Monetary Union 41
  • 79. Equilibrium in the Monetary Union 41
  • 80. Equilibrium in the Monetary Union 41
  • 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 42
  • 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? 42
  • 83. A Rise in pT pN pT cN κ pT Unemployment 43
  • 84. A Rise in pT pN pT cN κ pT pT ↑ Unemployment 43
  • 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 ↑ 44
  • 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? 44
  • 87. Default in the Monetary Union c2 c1cD,1 cD,2 Default 45
  • 88. Default in the Monetary Union c2 c1cD,1 cD,2 Default cT,R (bH,1) cR ¯b New Def’t Thr. cD,2 45
  • 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 46
  • 90. Default at the Zero Lower Bound What if the ZLB prevents expansionary monetary policy? 47
  • 91. ZLB Equilibrium - Repay 48
  • 92. ZLB Equilibrium - Default 49
  • 93. Default at the Zero Lower Bound What if the ZLB prevents expansionary monetary policy? ZLB causes equilibrium pT to be lower 50
  • 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 52
  • 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 52
  • 98. Outline Model Heterogeneity within the Monetary Union Nominal Rigidities Risky Borrowing and Default Results Sovereign Default Monetary Policy 53
  • 99. Preferences over Monetary Policy How would countries want Monetary Policy to be run? 54
  • 100. Preferences over Monetary Policy How would countries want Monetary Policy to be run? 54
  • 101. Preferences over Monetary Policy Countries in H are doves They want expansionary policy, a high target p∗ 1 55
  • 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 55
  • 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. . . 55
  • 104. Preferences over Monetary Policy - F Initial-period monetary relaxation implies terminal-period tightening p∗ 1 ↑ ⇒ πT,2 ↓ 56
  • 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∗ 56
  • 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 56
  • 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 56
  • 108. Monetary Policy Preferences and Default Can the threat of default milden savers’ hawkish tendencies? 57
  • 109. Monetary Policy Preferences and Default Can the threat of default milden savers’ hawkish tendencies? Suppose that H just about prefers to default 57
  • 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 57
  • 111. Monetary Policy Preferences and Default c2 c1cD,1 cD,2 Default cT,R (bH,1) cD,2 cR ¯b 58
  • 112. Monetary Policy Preferences and Default c2 c1cD,1 cD,2 Default cT,R (bH,1) cD,2 cR ¯b p∗ 1 ↑ 58
  • 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 59
  • 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 59
  • 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 59
  • 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 60
  • 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 60
  • 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 60
  • 120. Households - Appendix Budget constraints pT,1cT,i,1 + pN,i,1cN,i,1 + bM,i 1 + i = pT,1 (yT,i,1 + si,1) + wi,1li,1 pT,2cT,i,2 + pN,i,2cN,i,2 = pT,2 (yT,i,2 + si,2) + bM,i + wi,2li,2 Households 62