Monetary Policy and Sovereign Debt Vulnerability

Abstract

for helpful comments and suggestions. All remaining errors are ours.

A Stochastic Model of Optimal Debt Management and Bankruptcy

“…To offset this possible loss, the investor buys a bond with unit nominal value at a discounted price p ∈ [0, 1]. As in [8,13], at any time t the value p(t) is uniquely determined by the competition of a pool of risk-neutral lenders.…”

“…Here µ ≥ 0 is an exponential growth rate, while W denotes Brownian motion on a filtered probability space. Differently from [7,8], in [13] it is the borrower himself that chooses when to declare bankruptcy. This decision will be taken when the debt-to-income ratio reaches a certain threshold x * , beyond which the burden of servicing the debt becomes worse than the cost of bankruptcy.…”

“…Aim of the present paper is to provide a detailed mathematical analysis of some models closely related to [13]. We stress that these problems are very different from a standard problem of optimal control.…”

Sovereign finance in emerging markets

“…The second related literature focuses on nominal debt when monetary policy is discretionary and explicit default is possible 3 . Nuño and Thomas (2016) and Onder and Sunel (2016), inspired by the recent experience of countries in the periphery of the Euro area, find that welfare is higher when debt is issued in FC and there are no incentives to create inflation. These papers, however, use models with a single traded of good, neglecting, therefore, real exchange rate movements.…”

“…Among others, examples are i) self-fulfilling debt crises in small economies and in monetary unions (Aguiar et al 2013, and Araujo et al 2013; ii) the origin of the default risk on LC sovereign debt coming from FC corporate borrowing and the consequent currency mismatch ; iii) how the exogenous cyclicality of the inflation rate influences debt sustainability in a closed economy (Hur, Kondo and Perri, 2017); iv) the complementary role of seigniorage in economies with debt and money (Rottger, 2016, andSunder-Plassmann, 2017, with cash-inadvance constraints, and Fried, 2017, with search frictions). 4 Ottonello and Perez (2018) present an extension of their benchmark model including outright default in appendix D. I use a particular case in which governments issue LC or FC debt as Gumus (2013), Nuño and Thomas (2016), and Onder and Sunel (2016) do. Differently from the analysis of Ottonello and Perez (2018), I discuss the policy functions of the model, present calculations of the welfare change from issuing LC debt for different degrees of monetary policy credibility and show how the results persist in the presence of risk-averse lenders.…”