Central bank intervention, public debt and interest rate target zones

The euro area crisis has been characterized by speculative attacks reflecting the market fear that some high indebted countries could go bankrupt. What is puzzling, however, is that non-euro area countries with an equally large – and in some cases even larger - public debt-to-GDP ratios have not been subject to attacks. Both facts have been explained by observing that euro area countries could not rely on a lender of last resort, so as to make possible the occurrence of self-fulfilling speculative attacks. The model proposed in this article applies the target zones methodology relative to exchange rates, developed in the late 1980s-early 1990s, to the case of interest rates. Its novelty is that it endogenizes the determinants of the credibility of the interest rate target zone and, as a result, of public debt stability: the latter is shown to depend on the liquidity (that can be interpreted as the availability of reserves) that the central bank can create thanks to its role of lender of last resort: full/partial credibility is obtained when reserves are expected to be sufficient/insufficient to absorb completely the excess of supply of bonds resulting from a given demand shock. Moreover, the expected absence of reserves determines the non-credibility of the interest rate target, while the expectation of a public debt increase produces the convex interest rate nonlinearity that characterized the euro area crisis.