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Fiscal Imbalances, Inflation and Sovereign Default Dynamics

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  • Guillard, Michel
  • Sosa Navarro, Ramiro

Abstract

The central question this paper seeks to answer is how monetary policy might affect the equilibrium behavior of default and sovereign risk premium. The paper is based on �one-interest-rate� model. Public debt becomes risky due to an active fiscal policy, as in Uribe (2006), reflecting the fiscal authority’s limited ability to control primary surplus. The insolvency problem is due to a string of bad luck (negative shocks affecting primary surplus). But in contrast to Uribe’s results, as the sovereign debt cost increases (which result from weak primary surplus), default becomes anticipated and reflected by a rising country risk premium and default probability. The default is defined as reneging on a contractual agreement and so the decision is set by the fiscal authority. However, conflicting objectives between fiscal and monetary authority play an important role in leading fiscal authority to default on its liabilities. The characteristic of the government policy needed to restore the equilibrium after the default is also analyzed.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 24075.

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Date of creation: Dec 2009
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Handle: RePEc:pra:mprapa:24075

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Keywords: Fiscal Imbalances; Inflation; Sovereign Risk; Default;

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  1. Martin Uribe, 2002. "A Fiscal Theory of Sovereign Risk," NBER Working Papers, National Bureau of Economic Research, Inc 9221, National Bureau of Economic Research, Inc.
  2. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(2), pages 379-408, May.
  3. Bennett T. McCallum, 1982. "Price Level Determinacy with an Interest Rate Policy Rule and Rational Expectations," NBER Working Papers, National Bureau of Economic Research, Inc 0559, National Bureau of Economic Research, Inc.
  4. Dirk Niepelt, 2004. "The Fiscal Myth of the Price Level," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 119(1), pages 276-299, February.
  5. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 115(1), pages 147-180, February.
  6. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 195-214, December.
  7. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 27(1), pages 129-147, February.
  8. W.H. Buiter, 2000. "The Fallacy of the Fiscal Theory of the Price Level," CEP Discussion Papers, Centre for Economic Performance, LSE dp0447, Centre for Economic Performance, LSE.
  9. Sosa Navarro, Ramiro, 2005. "Default Recovery Rates and Implied Default Probability Estimations: Evidence from the Argentinean Crisis," MPRA Paper, University Library of Munich, Germany 11054, University Library of Munich, Germany.
  10. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 83(2), pages 241-54, April.
  11. John H. Cochrane, 1999. "Portfolio Advice for a Multifactor World," CRSP working papers, Center for Research in Security Prices, Graduate School of Business, University of Chicago 491, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  12. Pau Rabanal, 2004. "Monetary Policy Rules and the U.S. Business Cycle," IMF Working Papers, International Monetary Fund 04/164, International Monetary Fund.
  13. Michael Woodford, 1995. "Price Level Determinacy Without Control of a Monetary Aggregate," NBER Working Papers, National Bureau of Economic Research, Inc 5204, National Bureau of Economic Research, Inc.
  14. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, Springer, vol. 4(3), pages 345-80.
  15. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, National Bureau of Economic Research, Inc, number tayl99-1.
  16. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, Springer, vol. 4(3), pages 381-99.
  17. Willem H. Buiter, 2001. "The fallacy of the fiscal theory of the price level, again," Bank of England working papers, Bank of England 141, Bank of England.
  18. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers, National Bureau of Economic Research, Inc 8072, National Bureau of Economic Research, Inc.
  19. Bennett T. McCallum, 2001. "Should Monetary Policy Respond Strongly to Output Gaps?," American Economic Review, American Economic Association, American Economic Association, vol. 91(2), pages 258-262, May.
  20. Marco Arena & Carmen Reinhart & Francisco Vázquez, 2006. "The Lending Channel in Emerging Economics: Are Foreign Banks Different?," NBER Working Papers, National Bureau of Economic Research, Inc 12340, National Bureau of Economic Research, Inc.
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