A government, whose debt is denominated in its own currency, need never face default. In the event of insolvency, created by an unexpected spending need or revenue shortfall, the country can always restore solvency with seigniorage (Sargent and Wallace 1981) and/or debt devaluation through unexpected inflation. Monetary union eliminates these instruments unless the union is willing to sacrifice price stability to restore solvency for an individual country. The European Central Bank has a single mandate of price stability, and no explicit mandate for individual country fiscal solvency.
Founders of the European Monetary Union were concerned that fiscal insolvency could threaten the currency union. They sought to replace the loss of individual-country monetary policy instruments with more prudent fiscal policy by placing limits on debt and the deficit. However, the world-wide financial crisis and recession, which began in 2007 and accelerated in 2008, has had profoundly negative consequences for government budget deficits and debt, with almost all countries in violation of the limits. In 2009 and 2010, interest rates for some countries relative to German rates spiked, reflecting market concern that these countries might default on their debt. What does economic theory have to offer about market concerns that some EMU countries could default?
High interest rate currencies tend to appreciate relative to low interest rate currencies. This is the forward premium puzzle as one would expect that investors would demand higher interest rates on currencies expected to depreciate. This anomaly underlies the profitability of the so called carry trade, under which investors borrow in low interest rate currencies and invest in high interest rate currencies. Related to this anomaly, exchange rates often exhibit momentum in response to interest rate differential shocks. That is, when there is a positive innovation to the interest rate differential, the exchange rate appreciates at impact. The puzzle is that it continues appreciating for several months thereafter. Standard models predict an immediate appreciation followed by a depreciating path.
Agents interact in markets as well as socially, that is, in the various socio economic groups they belong to. Models of social interactions are designed to capture in a simple abstract way socio economic environments inwhich markets do not mediate all of agents’ choices. In such environments agents’ choices are determined by their preferences as well as by their ability to interact with others, on their position in a predetermined network of relationships, e.g., a family, a peer group, or more generally any socio economic group.
