Inflation Targeting with Sovereign Default Risk

During the 1980s and 1990s emerging markets experienced recurrent episodes of high inflation and debt crises with high sovereign default premia, and many default events. Since the 2000s, inflation has come down in many of these emerging markets and debt crises have been limited. These developments have occurred as central banks in emerging markets have become more independent and have adopted a monetary policy of setting interest rates to target inflation. In this paper we study the interplay of monetary policy and sovereign default risk and show that inflation target induce not only lower inflation rates but also lower default risk of sovereign debt.