Monetary Conservatism, Default Risk, and Political Frictions

This paper studies the consequences of delegating monetary policy to an inflation conservative central banker as in Rogoff (1985) for an emerging economy that faces three frictions which might undermine the success of such a policy reform: (i) incomplete financial markets, (ii) risk of default and (iii) political distortions. To do so, a quantitative sovereign default model is developed in which monetary and fiscal policies are set by two different authorities that both cannot commit to future policies. Inflation conservatism tends to result in lower and more stable inflation as well as a higher average debt burden, more frequent default events and more volatile fiscal policy. Whether the economy benefits from the appointment of a conservative central banker depends on the degree of inflation conservatism, the amount of political distortions and the volatility of fiscal shocks.