Exit Risks and Contagion in the Euro Area

This paper aims to assess the possible impact that the depreciation of a common currency can have on the stability of the related monetary union. It shows that, other things being equal, this depreciation reduces the probability of the weakest Member States leaving the monetary union when hit by a specific and negative demand shock, and the probability of other Member States, which belong to the same area but are not directly hit by any shock, deciding to leave due to the contagion effect. Obviously, the depreciation of the common currency is not the only variable affecting the stability of a monetary area. In this respect, it is sufficient to recall that competition in the international markets is not just price competition. Hence, the paper also analyzes the role played by trade balance elasticities. In our framework, it emerges that higher (lower) elasticities of the weakest countries hit by the specific shock make their exit more (less) likely. Moreover, given the elasticities of these same countries, there is a threshold value in the elasticities of the other Member States under which contagion can never happen. It is apparent that this framework applies to the possible behavior of ‘peripheral’ countries in the European Economic and Monetary Union (EMU), and to their interactions with the rest of the area. Hence, this paper can be read as a strategic interaction between two representative countries of the euro area in order to identify the selection mechanisms between good and bad equilibria.