Sovereign Risk in the Euro Zone and Monetary Policy

We analyze monetary policy in a currency union with sovereign risk by using a three-country model including a two-country currency union and introduce an ad hoc assumption that one of the two countries is exposed to sovereign risk. In our model, if expected fiscal revenue is less than current public debt, one country can default whereas the other country cannot default. In a canonical setting that analyzes optimal monetary policy, the optimal monetary policy is consistent with the Taylor rule. However, the Taylor rule is not optimal and persistently causes defaults in our model. In contrast, an interest rate peg, namely government bonds swaps, terminates defaults after one period and is optimal in our model.