Sovereign Default and Monetary Policy Tradeoffs

Abstract

The paper is organized around the following question: when the economy moves from a debt-GDP level where the probability of default is nil to a higher level-the "fiscal limit"-where that default probability is non-negligible, how do the effects of routine monetary operations designed to achieve macroeconomic stabilization change? We find that the specification of the monetary policy rule plays a critical role. Consider a central bank that targets the risky rate. When the economy is near its fiscal limit, a transitory monetary policy contraction leads to a sustained rise in inflation, even though monetary policy actively targets inflation and fiscal policy passively adjusts taxes to stabilize debt. If the central bank targets the risk-free rate, on the other hand, the same transitory monetary contraction keeps inflation under control, but leads output to contract for a prolonged period of time. The comparison shows that sovereign default risk put into sharp relief the tradeoff between inflation and output stabilization.

Revisiting the Fiscal Theory of Sovereign Risk from a DSGE Viewpoint

“…The government chooses δ t = 0 if Ψ = 1. 8 Our default rule is different from those proposed by Uribe [32] and Bi, Leeper, and Leith [10]. Unlike Uribe [32], default in our model is consistent with government solvency and is not an ad hoc rule.…”

“…In fact, as pointed out by Reinhart and Rogoff [29], there is a strong observed relationship between default and inflation, with inflation in the year of default usually being quite high. Thus, our default rule is more plausible than those in either Uribe [32] or Bi, Leeper, and Leith [10].…”

“…Unlike Uribe [32], default in our model is consistent with government solvency and is not an ad hoc rule. 9 And unlike Bi, Leeper, and Leith [10], our default rule considers the channel where inflation mitigates default. Their default rule depends on a threshold of the ratio of debt over steady-state GDP, where the threshold is endogenously decided and depends on the government's solvency.…”

“…By using Gali and Monacelli's [21] definition of the output gap-i.e., ỹt ≡ y t − ȳt , where ỹt and ȳt denote the output gap and the natural rate of output, respectively-we can recognize that stabilizing the fiscal surplus leads to the stabilization of the output gap. 10…”

Fiscal Policy Risk and the Yield Curve: An Alternative Measure

“…This paper draws inspiration on the literature that examines the consequences of non-negligible fiscal risk and its impacts on monetary policy (Arellano, 2008;Arellano et al, 2020;Bi, 2012;Bi et al, 2018). Recently, such framework has been applied to monetary policy in the Brazilian context (Amaral & Carvalho, 2021;Carvalho & Mendonça, 2022), finding that economies subject to fiscal risk can face high interest rates co-existing with high inflation if the monetary authority does not account for risk in the policy asset.…”