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In the aftermath of the global financial crisis, sovereign default risk and the zero lower bound have limited the ability of policy-makers in the European monetary union to achieve their stabilization objective. This paper investigates the interaction between sovereign default risk and the conduct of monetary policy, when borrowers can act strategically and they share with their lenders a single currency in a monetary union. We address this question in an endogenous sovereign default model of heterogeneous countries in a monetary union, where the monetary authority may be constrained by the zero lower bound. We uncover three main results. First, in normal times, debtors have a stronger incentive to default to induce more expansionary monetary policy. Second, the zero lower bound, or constraints on monetary policy may act as a disciplining device to enforce repayment of sovereign debt. Third, sovereign default risk induces countries with a preference for tight monetary policy to accept a laxer policy stance. These results help to shed light on the recent European experience of high default risk, expansionary monetary policy and low nominal interest rates. ; The ADEMU Working Paper Series is being supported by the European Commission Horizon 2020 European Union funding for Research & Innovation, grant agreement No 649396.

We study the monetary-fiscal mix in the European Monetary Union. The medium and long-run effects of conventional and unconventional monetary policy are analysed by combining monetary policy shocks identified in a Structural VAR, and the general government budget constraint featuring a single central bank and multiple fiscal authorities. In response to a conventional easing of the policy rate, the cumulated response of the fiscal deficit is positive. Conversely, in response to an unconventional easing affecting the long end of the yield curve, the primary fiscal position barely moves. This is consistent with the long-run effect of unconventional monetary easing on the price index, which is about half that of conventional easing. The aggregate long-run cumulated surplus is mainly driven by Germany's fiscal policy during the period in which unconventional monetary policy was adopted.

We study the monetary-fiscal mix in the European Monetary Union. The medium and long-run effects of conventional and unconventional monetary policy are analysed by combining monetary policy shocks identified in a Structural VAR, and the general government budget constraint featuring a single central bank and multiple fiscal authorities. In response to a conventional easing of the policy rate, the cumulated response of the fiscal deficit is positive. Conversely, in response to an unconventional easing affecting the long end of the yield curve, the primary fiscal position barely moves. This is consistent with the long-run effect of unconventional monetary easing on the price index, which is about half that of conventional easing. The aggregate long-run cumulated surplus is mainly driven by Germany's fiscal policy during the period in which unconventional monetary policy was adopted.