Journal of Finance and Economics

Journal of Finance and Economics

ISSN: 2291-4951 (Print)    ISSN: 2291-496X (Online)

Volume 4 (2016), No. 4, Pages 11-23

DOI: 10.12735/jfe.v4n4p11

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Monetary Union Dynamics with Unsustainable Public Debt

Marcello Esposito1 

1Economics and Management School, Università “Carlo Cattaneo”, Castellanza, Italy

URL: http://dx.doi.org/10.12735/jfe.v4n4p11

To Cite this Article     Article Views: 549     Downloads: 303  Since deposited on 2016-10-12

Abstract

The goal of this paper is to model the dynamics of an economy belonging to a monetary union, when the possibility of leaving that union arises. For this, we extend the Drazen-Helpman (1990) model, introducing a new component of the interest rate, i.e. the "spread", that allows for bridging the interest rates’ dynamics inside the union with the anticipated future outside the union.

   In the context of the neoclassical Ramsey infinite horizon model, with optimizing individuals and competitive markets, the spread, differently from inflation, affects the real side of the economy as a sort of distortionary taxation on investments. This implies that a country belonging to the monetary union but characterized by weak public finances will suffer from lower capital accumulation, lower output, and lower consumption levels than the ones achievable by the steady state "golden rule". In reality, we will show that Pareto-optimality requires either to embrace the path to a fiscal union or to break-up.

   In this paper the focus is on the break-up option, when public debt becomes unsustainable. We analyse the dynamics of the economy before and after the break-up, with specific attention to interest rates, capital accumulation and exchange rate. We derive that the nominal interest rate will not change around the break-up event, thanks to the “bridging” property of the spread. The real interest rate instead will decrease, and consumption will jump down, allowing for higher investments necessary to reconstitute the optimal stock of capital. The exchange rate will overshoot initially and then will appreciate, converging toward the new equilibrium level.

JEL Classifications: E58, E63, H63

Keywords: debt monetization, monetary union, seignorage, sovereign risk and default

To Cite this Article: Esposito, M. (2016). Monetary union dynamics with unsustainable public debt. Journal of Finance and Economics, 4(4), 11-23. http://dx.doi.org/10.12735/jfe.v4n4p11

Copyright © Marcello Esposito

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This article is published under license to Science and Education Centre of North America. This is an Open Access article distributed under the terms of the Creative Commons Attribution 4.0 International License.

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Monetary Union Dynamics with Unsustainable Public Debt
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