This paper focuses on the possibility that financial markets require risk premia on holding sovereign debt of countries that appear vulnerable from a fiscal sustainability perspective. Both the level of debt as well as the rate of change of debt are assumed to impact on the risk premium. We analyze the impact of such an endogenous risk premium in a simple debt game between a monetary and a fiscal player, as introduced by [Tabellini (1986) Journal of Economic Dynamics and Control 10, 427–442]. The risk premium term adds a nonlinearity to the linear model in case risk premia are absent. We analyze outcomes in case of noncooperative open-loop Nash strategies and in case of cooperative strategies and consider the workings of the risk premium as a market-based disciplining device (in case of high debt) and adjustment rewarding device (in case of a declining debt trajectory).

Macroeconomic performance in the Economic and Monetary union (EMU) will be impaired if national fiscal policy flexibilityand monetary flexibility of the ECB islimited, goods markets adjustsluggishly, labor mobility is low, and automatic stabilization fromfederal taxes and government spending is low. This paper analyzes thestabilization of output fluctuations induced by symmetric andasymmetric macroeconomic shocks in the EMU. It is shown how nationalfiscal flexibility and flexibility of the monetary policy of the ECBcan stabilize fluctuations of the average EU business cycle that aregenerated by symmetric shocks. Furthermore, it is demonstrated how,under EMU, national fiscal flexibility and a system of fiscaltransfers are able to stabilize differences in national businesscycles that are generated by asymmetric shocks.