Working Paper

Asset Purchases in a Monetary Union with Default and Liquidity Risks

Abstract: Central bank asseUsing 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. The framework indicates that 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.t purchases can effectively stabilize economic conditions, especially in scenarios of elevated financial stress.

Keywords: Monetary and fiscal policy interaction; unconventional monetary policy; Regime-Switching Models;

JEL Classification: E58; E63; F45;

https://doi.org/10.18651/RWP2024-13

Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 2024-12-03

Number: RWP 24-13