Asset Purchases in a Monetary Union with Default and Liquidity Risks

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RWP 24-13, December 2024; updated July 2026

We develop a nonlinear two-country monetary union model with endogenous sovereign default and financial intermediation to study the effects of targeted asset purchases, and expectations of such programs, during sovereign debt crises. Default risk increases with government debt and shifts in investors’ perceptions of fiscal solvency. We calibrate the model to Italy and Germany during the 2012 European debt crisis; it reproduces key features of the data, including the periphery-core divergence in investment, output, and sovereign yields. Cross-border transmission depends on the substitutability of sovereign bonds: when bonds are poor substitutes, the crisis country contracts while the rest of the union expands, whereas highly substitutable bonds generate a synchronized downturn. During a debt crisis, asset purchases stabilize financial markets and the macroeconomy, and this stabilization can occur even if purchases are expected but never implemented. However, expectations of potential asset purchases can also distort normal-times activity by encouraging greater risk-taking.

JEL Classifications: E58, E63, F45