Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/309963 
Year of Publication: 
2024
Series/Report no.: 
Cardiff Economics Working Papers No. E2024/13
Publisher: 
Cardiff University, Cardiff Business School, Cardiff
Abstract: 
We build a model to study the interaction between default risk, policy changes, and financial frictions within a monetary union. The model features a centralised central bank and decentralised fiscal authorities. Countries have different reputations for fiscal stability, modelled as different probabilities of moving to a Default regime. Borrowing costs for the fiscal authority and firms are affected by the possibility of default. This creates a feedback effect between debt accumulation, reputation, and the depth of a recession following adverse shocks. In this context, we discuss the benefits and limitations of a coordinated monetary and fiscal policy response that removes the risk of default. Adverse energy shocks generate more benign outcomes if accommodated, while a fiscal crisis leads to a vicious circle of debt accumulation, recession, and inflationary pressure. In this case, default and inflation risks can reinforce each other.
Subjects: 
Euro Area
default
fiscal policy
inflation
large public debt
financial frictions
JEL: 
E50
E62
E30
Document Type: 
Working Paper

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