Monetary Policy and Sovereign Debt Sustainability

We analyze the consequences of monetary policy for sovereign debt sustainability and welfare in a model of a small open economy where the government issues long-term nominal debt without a commitment not to default on it or erode its real value through (costly) inflation. Inflation is a form of partial default, one that is more state-contingent than outright default. This reduces the government’s incentives to default outright and hence enlarges the repayment region, compared to a regime in which debt cannot be inflated away. Moreover, inflation delivers sizable welfare gains in situations of sovereign debt stress, in which its benefits as a debt-stabilizing tool are larger. Over the longer run, however, the welfare gains from inflation are more modest, because the inflationary bias leads the government to create inflation also in situations in which it is less useful for debt-stabilization purposes.