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Self-fulfilling debt crises: What can monetary policy do?

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  • Bacchetta, Philippe
  • Perazzi, Elena
  • van Wincoop, Eric

Abstract

This paper examines the potential for monetary policy to avoid self-fulfilling sovereign debt crises. We combine a version of the slow-moving debt crisis model proposed by Lorenzoni and Werning (2014) with a standard New Keynesian model. Monetary policy could preclude a debt crisis through raising inflation and output and lowering the real interest rate. These reduce the real value of outstanding debt and the cost of new borrowing, and increase tax revenues and seigniorage. We determine the optimal path of inflation required to avoid a self-fulfilling debt crisis. Stronger price rigidity implies more sustained inflation.

Suggested Citation

  • Bacchetta, Philippe & Perazzi, Elena & van Wincoop, Eric, 2018. "Self-fulfilling debt crises: What can monetary policy do?," Journal of International Economics, Elsevier, vol. 110(C), pages 119-134.
    • Handle: RePEc:eee:inecon:v:110:y:2018:i:c:p:119-134
    DOI: 10.1016/j.jinteco.2017.11.004
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    3. Cristina Arellano & Gabriel Mihalache & Yan Bai, 2018. "Inflation Targeting with Sovereign Default Risk," 2018 Meeting Papers 851, Society for Economic Dynamics.
    4. Giancarlo Corsetti, 2023. "Debt crises, fast and slow Giancarlo," RSCAS Working Papers 2023/15, European University Institute.
    5. Miklos Vari, 2020. "Monetary Policy Transmission with Interbank Market Fragmentation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 52(2-3), pages 409-440, March.
    6. Mitchener, Kris & Trebesch, Christoph, 2021. "Sovereign Debt in the 21st Century: Looking Backward, Looking Forward," CEPR Discussion Papers 15935, C.E.P.R. Discussion Papers.
    7. Niels Gilbert, 2019. "Euro area sovereign risk spillovers before and after the ECB's OMT announcement," DNB Working Papers 636, Netherlands Central Bank, Research Department.
    8. Kris James Mitchener & Christoph Trebesch, 2021. "Sovereign Debt in the 21st Century," NBER Working Papers 28598, National Bureau of Economic Research, Inc.
    9. Cristina Arellano & Gabriel Mihalache & Yan Bai, 2018. "Inflation Targeting with Sovereign Default Risk," 2018 Meeting Papers 851, Society for Economic Dynamics.

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