Inflation aversion and exit probabilities in the economic and monetary union (EMU)

This paper considers a monetary union composed of two countries characterized by different inflation aversions. The policymakers of the two countries minimize loss functions, defined by their output and inflation gap as well as an exogenous cost representing the loss of international credibility in case of exit from the EMU. The two countries strategically interact after an aggregate demand shock which only affects the peripheral country. The paper derives the possible Nash equilibria after the shock is observed by both players. If the shock is large enough, the peripheral country chooses to leave the monetary union. If the shock is still larger, the country not directly exposed to the shock can also choose to abandon the Euro, leading to the so-called contagion effect.

The main results are that the higher the inflation aversion of the country affected by the shock, the lower its exit probability. Furthermore the inflation aversion of the country not directly exposed to the demand shock does not affect the exit probability of the peripheral country.  Nevertheless, using reasonable values of parameters (i.e. exchange rate elasticities, trading shares and so on) and exogenous variables (i.e. the exogenous cost of the country leaving the Euro) this paper shows that higher levels of inflation aversion in both countries are associated with a lower probability of contagion.  If we assume that the two countries have the same inflation aversion, higher common inflation aversion results in a higher probability of exit for the peripheral country and a higher probability of contagion to the other economy.