Fiscal challenges to monetary dominance in the euro area: a theoretical perspective

The government debt and banking turmoil that persists in several euro area countries begs the question of why countries such as the United States or Japan, which do not have less debt, have not been affected by the same problems. To shed light on this question, two forms of monetary dominance should be distinguished. According to the first (soft, or preventive) form of monetary dominance, the government adjusts its fiscal policy so as to avoid having to choose between a default or debt monetisation. In the second case (hard form of monetary dominance), in the extreme situation where this choice has to be made, the monetary authorities let the government default rather than monetising the debt. We show that hard monetary dominance may reduce the probability of fiscal adjustment and, if it is not perfectly credible, may increase the probability of inflation.