In the aftermath of the recent European sovereign debt crisis, there have been many proposals to leave the Euro for South-European countries. Presumably, abandoning the currency union would benefit these countries by allowing them to monetize deficits. In this paper we argue that the risk of hyperinflation can be significant for these countries if they leave the Euro with positive and persistent deficits, large value of debt to output ratios. We consider a case when agents in the economy have incomplete information about the economy, thus we depart from rational expectations. We use the recently developped framework of "internal rationality". The paper also serves as a methodological exploration of how to perform policy analysis under internal rationality.

Juan Pablo Nicolini

Juan Pablo Nicolini is a senior research economist with the Federal Reserve Bank of Minneapolis. Prior to joining the Fed in 2009, Juan Pablo taught at the Instituto Tecnológico Autónomo de México, the Universitat Pompeu Fabra in Barcelona, and the Universidad Torcuato Di Tella in Buenos Aires, where he holds a part-time position. In addition, he served as chairman of the Economics Department (1994–99) and president (2001–9) of Universidad Torcuato Di Tella. In 2006–7, he was Tinker Visiting Professor in the Economics Department and the Center for Latin-American Studies at the University of Chicago. He has also been a visiting researcher at the Banco de Portugal and in the Monetary Stance Division of the European Central Bank.

Juan studied economics at the Universidad Nacional de Tucumán in Argentina and earned M.A. and Ph.D. degrees in economics from the University of Chicago. The focus of his research centers on monetary theory and policy and on bounded rationality in macroeconomics. Juan’s work has appeared in several journals, among them the Journal of Political Economy, American Economic Review, Journal of Monetary Economics, Review of Economic Dynamics, and Journal of Economic Dynamics and Control.