RWP 24-13, December 2024
Using a two-country monetary-union framework with financial frictions, we study sovereign default and liquidity risks and quantify the efficacy of asset purchases. Default risk increases with government indebtedness and shifts in the fiscal limit perceived by investors. Liquidity risks increase when the default probability affects credit market tightness. Shifts in fiscal limits, more than rising government debt, played a crucial role for Italy around 2012. While both default and liquidity risks can dampen economic and financial conditions, the model suggests that the magnifying effect from liquidity risks can be more consequential. In this context, asset purchases can stabilize economic conditions especially under scenarios of elevated financial stress.
JEL Classifications: E58, E63, F45
Article Citation
Bi, Huixin, Andrew Foerster, and Nora Traum. 2024. “Asset Purchases in a Monetary Union with Default and Liquidity Risks.” Federal Reserve Bank of Kansas City, Research Working Paper no. 24-13, December. Available at External Linkhttps://doi.org/10.18651/RWP2024-13