Theory and Practice of Contagion in Monetary Unions: Domino Effects in Emu Mediterranean Countries

By Canofari, Paolo; Bartolomeo, Giovanni Di et al. | International Advances in Economic Research, August 2014 | Go to article overview

Theory and Practice of Contagion in Monetary Unions: Domino Effects in Emu Mediterranean Countries


Canofari, Paolo, Bartolomeo, Giovanni Di, Piersanti, Giovanni, International Advances in Economic Research


Abstract This paper analyzes strategic interactions and contagion effects in the peripheral countries of a monetary union. Using game theory and cost-benefit analysis, the paper determines the set of equilibrium solutions under which country-specific shocks are transmitted to other member countries giving rise to contagion. Numerical simulations, obtained by a simple calibration of the model on some key Mediterranean countries of the Euro Zone, show the probabilities of contagion from Greece, Spain and Italy.

Keywords Shadow exchange rate * Currency crisis * Monetary unions * Contagion * Nash equilibria

JEL Codes F30 * F31 * F41 * G01

Introduction

The spectacular increase of sovereign risk premium in the Euro Area following the Greek debt explosion in 2009 and its impact on the sustainability of the European Monetary Union (EMU) have kindled research interest in contagion effects and risk of a systemic crisis in the Euro Zone. The issue has also been of major concern to European policymakers and it has brought the containment of systemic financial crises to the center of an international policy debate.

There is now substantial literature dealing with the European debt crisis, the bulk of it focusing on the role played by fiscal and financial variables in the outbreak of crisis. (1) There are also some recent papers that focuses on the role spillover and contagion effects played in exacerbating the sovereign debt problems in the Euro Zone. (2) A major deficiency of this literature is that it still lacks a rigorous theoretical framework to understand the full set of events characterizing the sovereign debt crisis and contagion effects within the EMU. However, some exceptions should be mentioned. Bolton and Jeanne (2011) propose a model of contagious sovereign debt crises in financially integrated economies. Arghyrou and Kontonikas (2012) provide a model of the Euro Zone crisis that combines the features of both second- and third-generation approaches to currency crises. De Grauwe and Ji (2013) present a model of EMU sovereign crisis inspired by the Obstfeld (1996, 1997) model of self-fulfilling-speculative attacks. Canofari et al. (2012b) propose a model of crisis and contagion within monetary unions that combines the features of both first- and second-generation approaches to currency crises. (3)

Our paper adds to the above strand of literature by providing a new theoretical framework to understand crises and contagion phenomena within monetary unions. Specifically, we apply game theory and a cost-benefit analysis to study voluntary exits and contagion effects in peripheral countries of a monetary union. The paper looks at two non-core, or periphery, countries of a large union and examines the role of strategic interactions and structural asymmetries in determining the set of equilibrium solutions following a country-specific shock.

The paper is organized as follows. We first discuss the theoretical framework. We then apply the model to the case of Euro Mediterranean countries to assess the probability of contagion under different assumptions about the exit costs. We finally summarize the main results.

The Theoretical Framework

To analyze voluntary exits and contagion effects in a monetary union, we look at a stochastic economy and a currency-union two-stage game where each member country, conditional on the realization of exogenous shocks that cause deviations of the target variables from their preferred level, can either choose to remain in the monetary union or exit by comparing the welfare losses arising from alternative optimal policy in each regimes. (4)

Specifically, we consider a monetary union where two periphery member countries (A and B) strategically interact. To be consistent with the second-generation approach, we also include a costly escape clause in the policymaker's loss function. The social loss is given by a standard function defined over the output gap and inflation (measured by the change in nominal exchange rate). …

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