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We develop a framework to study sovereign debt default when debtors and creditors belong to a monetary union. Three facts from the recent euro area experience motivate our analysis. First, the majority of external sovereign debt in the euro area is held within the union itself. Second, the European Central Bank was a key actor in the sovereign debt crisis, launching extraordinary policy measures when sovereign default risk became heightened in large debtor countries such as Italy. Third, low nominal interest rates constrained the action of the central bank, due to the presence of the zero lower bound. We uncover three main results. First, the incentive to default is stronger when large debtor countries understand that the monetary authority reacts to default in an expansionary way, to prevent a deflation. Second, the presence of constraints on monetary policy reduces the default incentive and acts as a repayment-enforcing device. Third, the threat of default by debtors can induce creditor countries to advocate for a more expansionary monetary policy stance
Link to paper: www.dropbox.com/s/sro4iqi8jyfg4kq/SDMU_dFR.pdf?dl=0
