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Sovereign Default and the Stability of Inflation Targeting Regimes

Author

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  • Andreas Schabert

    (TU Dortmund University , University of Amsterdam)

  • Sweder J.G. van Wijnbergen

    (University of Amsterdam)

Abstract

This discussion paper resulted in a publication in the 'IMF Economic Review' , 2014, 62(2), 261-287. 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.

Suggested Citation

  • Andreas Schabert & Sweder J.G. van Wijnbergen, 2011. "Sovereign Default and the Stability of Inflation Targeting Regimes," Tinbergen Institute Discussion Papers 11-064/2/ DSF20, Tinbergen Institute.
    • Handle: RePEc:tin:wpaper:20110064
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    References listed on IDEAS

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    Cited by:

    1. Markus Kirchner & Malte Rieth, 2021. "Sovereign Default Risk, Macroeconomic Fluctuations and Monetary–Fiscal Stabilization," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 69(2), pages 391-426, June.
    2. Dennis Bonam & Jasper Lukkezen, 2019. "Fiscal and Monetary Policy Coordination, Macroeconomic Stability, and Sovereign Risk Premia," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 51(2-3), pages 581-616, March.
    3. Giancarlo Corsetti & Keith Kuester & André Meier & Gernot J. Müller, 2013. "Sovereign Risk, Fiscal Policy, and Macroeconomic Stability," Economic Journal, Royal Economic Society, vol. 0, pages 99-132, February.
    4. Alho, Kari E.O., 2011. "How to Restore Sustainability of the Euro?," Discussion Papers 1259, The Research Institute of the Finnish Economy.
    5. 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.
    6. Corsetti, Giancarlo & Kuester, Keith & Meier, André & Müller, Gernot J., 2014. "Sovereign risk and belief-driven fluctuations in the euro area," Journal of Monetary Economics, Elsevier, vol. 61(C), pages 53-73.
    7. Dennis Bonam & Jasper Lukkezen, 2013. "Government Spending Shocks, Sovereign Risk and the Exchange Rate Regime," Tinbergen Institute Discussion Papers 13-212/VI, Tinbergen Institute, revised 09 Jan 2013.
    8. Kaufmann, Christoph & Attinasi, Maria Grazia & Hauptmeier, Sebastian, 2023. "Macroeconomic stabilisation properties of a euro area unemployment insurance scheme," Journal of Economic Dynamics and Control, Elsevier, vol. 153(C).
    9. Christiaan Kwaak & Sweder Wijnbergen, 2017. "Sovereign debt and bank fragility in Spain," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 153(3), pages 511-543, August.
    10. 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.
    11. Dennis Bonam & Jasper Lukkezen, 2013. "Government Spending Shocks, Sovereign Risk and the Exchange Rate Regime," Tinbergen Institute Discussion Papers 13-212/VI, Tinbergen Institute, revised 09 Jan 2013.
    12. Dennis Bonam & Jasper Lukkezen, 2014. "Fiscal and Monetary Policy Coordination, Macroeconomic Stability, and Sovereign Risk," Tinbergen Institute Discussion Papers 14-006/VI, Tinbergen Institute.
    13. Ignacio Lozano-Espitia & Fernando Arias-Rodríguez, 2022. "The Relationship between Fiscal and Monetary Policies in Colombia: An Empirical Exploration of the Credit Risk Channel," Borradores de Economia 1196, Banco de la Republica de Colombia.
    14. Guilherme Bandeira, 2018. "Fiscal transfers in a monetary union with sovereign risk," Working Papers 1807, Banco de España.
    15. Lozano-Espitia, Ignacio & Arias-Rodríguez, Fernando, 2022. "The Relationship between Fiscal and Monetary Policies in Colombia: An Empirical Exploration of the Credit Channel," Latin American Journal of Central Banking (previously Monetaria), Elsevier, vol. 3(4).
    16. Giancarlo Corsetti & Keith Kuester & Andre Meier & Gernot J. Müller, 2011. "Soverign risk and the effects of fiscal retrenchment in deep recessions," Working Papers 11-43, Federal Reserve Bank of Philadelphia.
    17. Sweder van Wijnbergen & Nina Budina, 2011. "Fiscal Sustainability, Volatility and Oil Wealth: A Stochastic Analysis of Fiscal Spending Rules," Tinbergen Institute Discussion Papers 11-068/2, Tinbergen Institute, revised 16 May 2011.
    18. Dennis Bonam & Bart Hobijn, 2021. "Generalized Stability of Monetary Unions Under Regime Switching in Monetary and Fiscal Policies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 53(1), pages 73-94, February.

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    More about this item

    Keywords

    Inflation targeting; fiscal-monetary policy interactions; sovereign default risk; foreign debt;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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