We study the characteristics of inflation targeting as a shock absorber, using quarterly data for a large panel of countries. To overcome an endogeneity problem between monetary regimes and the likelihood of crises, we propose to study large natural disasters. We find that inflation targeting improves macroeconomic performance following such exogenous shocks. It lowers inflation, raises output growth, and reduces inflation and growth variability compared to alternative monetary regimes. This performance is mostly due to a different response of monetary policy and fiscal policy under inflation targeting. Finally, we show that only hard but not soft targeting reaps the fruits: deeds, not words, matter for successful monetary stabilization.
We study the characteristics of inflation targeting as a shock absorber, using quarterly data for a large panel of countries. To overcome an endogeneity problem between monetary regimes and the likelihood of crises, we propose to study large natural disasters. We find that inflation targeting improves macroeconomic performance following such exogenous shocks. It lowers inflation, raises output growth, and reduces inflation and growth variability compared to alternative monetary regimes. This performance is mostly due to a different response of monetary policy and fiscal policy under inflation targeting. Finally, we show that only hard but not soft targeting reaps the fruits: deeds, not words, matter for successful monetary stabilization.
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AbstractThis paper studies the bank-sovereign link in a dynamic stochastic general equilibrium set-up with strategic default on public debt. Heterogeneous banks give rise to an interbank market where government bonds are used as collateral. A default penalty arises from a breakdown of interbank intermediation that induces a credit crunch. Government borrowing under limited commitment is costly ex ante as bank funding conditions tighten when the quality of collateral drops. This lowers the penalty from an interbank freeze and feeds back into default risk. The arising amplification mechanism propagates aggregate shocks to the macroeconomy. The model is calibrated using Spanish data and is capable of reproducing key business cycle statistics alongside stylized facts during the European sovereign debt crisis.Key words: Sovereign default; Interbank market; Bank-sovereign link; NonRicardian effects; Secondary markets; Domestic debt; Occasionally binding constraint JEL Codes: E43; E44; F34; H63 * We wish to thank Niccolò Battistini, Dennis Bonam, Fernando Broner, Aitor Erce, Juan Carlos Hatchondo, Simon Junker, Stephan Luck, Alberto Martin, Guido Sandleris, Christoph Trebesch and Vivian Yue for valuable discussions and suggestions. We also would like to thank participants
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