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Sovereign Default and the Stability of Inflation Targeting Regimes

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Author Info

  • Andreas Schabert

    ()
    (TU Dortmund University , University of Amsterdam)

  • Sweder J.G. van Wijnbergen

    ()
    (University of Amsterdam)

Abstract

We analyse the impact of interactions between monetary and fiscal policy on macroeconomic stability. We find that in the presence of sovereign default beliefs a monetary policy, which aims to stabilize inflation through an active interest rate policy, will destabilize the economy if the feedback from debt surprises back to the primary surplus is too weak. This result, which relies on endogenous changes in the default premium, is at odds with the results in an environment without default risk, where an active monetarypolicy guarantees macroeconomic stability. The results are highly relevant for the design of fiscal and monetary policy in emerging markets where sovereign credibility is not well established. Recent debt developments in Western Europe and in the US suggest these results might become relevant for more mature financial markets too.

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 11-064/2/ DSF20.

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Date of creation: 12 Apr 2011
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Handle: RePEc:dgr:uvatin:20110064

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

Related research

Keywords: Inflation targeting; fiscal-monetary policy interactions; sovereign default risk; foreign debt;

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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.
  2. Alho, Kari E.O., 2011. "How to Restore Sustainability of the Euro?," Discussion Papers 1259, The Research Institute of the Finnish Economy.
  3. van der Kwaak, C.G.F. & van Wijnbergen, S.J.G., 2014. "Financial fragility, sovereign default risk and the limits to commercial bank bail-outs," Journal of Economic Dynamics and Control, Elsevier, vol. 43(C), pages 218-240.
  4. Keith Kuester & Gernot J. Mueller & Giancarlo Corsetti & André Meier, 2012. "Sovereign Risk, Fiscal Policy, and Macroeconomic Stability," IMF Working Papers 12/33, International Monetary Fund.
  5. Giancarlo Corsetti & Keith Kuester & Andre Meier & Gernot J. Muller, 2011. "Soverign risk and the effects of fiscal retrenchment in deep recessions," Working Papers 11-43, Federal Reserve Bank of Philadelphia.

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