"Haircuts" for the EMU Periphery: Virtue or Vice?

We use a dynamic game model of a two-country monetary union to study the impacts of an exogenous fall in aggregate demand, the resulting increase in public debt, and the consequences of a sovereign debt haircut for a member country or bloc of the union. In this union, the governments of participating countries pursue national goals when deciding on fiscal policies, while the common central bank s monetary policy aims at union-wide objective variables. The union considered is asymmetric, consisting of a core with lower initial public debt, and a periphery with higher initial public debt. The periphery may experience a debt relief ( haircut ) due to an evolving high sovereign debt. Calibrating the model to the Euro Area, we calculate numerical solutions of the dynamic game between the governments and the central bank using the OPTGAME algorithm. We show that a haircut as modeled in our study is disadvantageous for both the core and the periphery of the monetary union. Moreover, the cooperative solution is preferable to the noncooperative equilibrium solution (both without and with a haircut ), providing an argument for coordinated fiscal policies in a monetary union.