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Debt, Deficits, and Destabilizing Monetary Policy in Open Economies

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  • Andreas Schabert

    ()
    (University of Amsterdam)

  • Sweder van Wijnbergen

    ()
    (University of Amsterdam)

Abstract

Blanchard (2005) suggested that active interest rate policy might induce unstable dynamics in highly-indebted economies. We examine this in a dynamic general equilibrium model where Calvo-type price rigidities provide a rationale for inflation stabilization. Unstable dynamics can occur when the CB is aggressively raising the interest rate in response to higher expected inflation. The constraint on stabilizing interest rate policy is tighter the higher the primary deficit and the more open the economy is. If the government cannot borrow from abroad in its own currency, stability requires interest rate policy to be accommodating (passive). Inflation stabilization is nevertheless feasible if the CB uses an instrument not associated with default risk, e.g. money supply.

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 06-045/2.

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Date of creation: 17 May 2006
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Handle: RePEc:dgr:uvatin:20060045

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Web page: http://www.tinbergen.nl

Related research

Keywords: Fiscal-monetary policy interactions; sovereign default risk; foreign debt; inflation targeting; original sin;

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Cited by:
  1. Sweder Wijnbergen & Alexander France, 2012. "Assessing Debt Sustainability in a Stochastic Environment: 200 Years of Dutch Debt and Deficit Management," De Economist, Springer, vol. 160(3), pages 219-236, September.

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