Withdrawal of Italy from the euro area: Stochastic simulations of a structural macroeconometric model

- We simulate the impact on the Italian economy of withdrawal from the euro area.
- The model endogenises sovereign spread dynamics and balance sheet effects.
- Due to banking crisis, nominal realignment has short-run contractionary effects.
- Reversing austerity policies allows growth to resume after the second year.
- Results are robust to different types of adjustment, with and without overshooting.

This paper assesses the impact on the Italian economy of Italy withdrawing from the euro area by means of stochastic simulations of a macroeconometric model. The model considers the effect of devaluation on output, sovereign debt valuation, and the development of bilateral economic relations between Italy and its major trade partners. The simulation results are consistent with the findings of recent applied research: the Italian economy would follow the V-shaped pattern observed in most currency crises. After an initial period of stress, and provided an appropriate set of countercyclical policy measures is implemented, real GDP would recover and resume growth at a reasonable pace. In particular, while the expected positive impact of nominal exchange rate realignment on external balance would be transitory, higher nominal growth would bring about a persistent reduction in unemployment and the public debt-to-GDP ratio. These results are robust to a set of sensitivity checks, considering a number of adverse circumstances such as exchange rate overshooting, financial panic, supply-side constraints, and the application of retaliatory tariffs.