Sovereign Default in a Currency Area: A Monetary General Equilibrium Model

Abstract

Real exchange rate overvaluation can induce default. In a currency area formed by two countries, we prove that if prices differ even slightly then inflations will diverge persistently and monetary policy will be unable to suit all currency area members. In fact, it will affect area members inversely. We show that risk premia are time-varying and determined by real exchange rate overvaluation. Finally, we find a transmission mechanism from the overvaluation of the real exchange rate of a currency area member to his default.