Exit expectations in currency unions

The adoption of a common currency is not irreversible. In this paper, we develop a model of a small open economy which is initially part of a currency union. We show that, first, expectations of regime change arise necessarily in equilibrium, if fiscal policy fails to stabilize public debt. A regime change implies an alternative fiscal policy or, through exit from the union, monetary autonomy. Second, if monetary policy is expected to revalue debt after exit, yield spreads rise prior to exit, reflecting redenomination risk. We explore the macroeconomic implications of redenomination risk by calibrating the model to Greek data