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In the aftermath of the global financial crisis, sovereign default risk and the zero lower bound have limited the ability of policy-makers in the European monetary union to achieve their stabilization objective. This paper investigates the inter-
action between sovereign default risk and the conduct of monetary policy, when borrowers can act strategically and they share with their lenders a single currency in a monetary union. We address this question in an endogenous sovereign default
model of heterogeneous countries in a monetary union, where the monetary authority may be constrained by the zero lower bound. We uncover three main results. First, in normal times, debtors have a stronger incentive to default to induce more
expansionary monetary policy. Second, the zero lower bound, or constraints on monetary policy may act as a disciplining device to enforce repayment of sovereign debt. Third, sovereign default risk induces countries with a preference for tight
monetary policy to accept a laxer policy stance. These results help to shed light on the recent European experience of high default risk, expansionary monetary policy and low nominal interest rates.
