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Monetary policy and sovereign debt vulnerability

Author

Listed:
  • Galo Nuño

    () (Banco de España)

  • Carlos Thomas

    (Banco de España)

Abstract

We investigate the trade-offs between price stability and the sustainability of sovereign debt, using a small open economy model where the government issues nominal defaultable debt and chooses fiscal and monetary policy under discretion. Inflation reduces the real value of outstanding debt, thus making it more sustainable; but it also raises nominal yields and entails direct welfare costs. We compare this scenario with a situation in which the government gives up the ability to deflate debt away, e.g. by issuing foreign currency debt or joining a monetary union with an anti-inflationary stance. We find that the benefits of giving up this adjustment margin outweigh the costs, both for our preferred calibration and for a wide range of parameter values.

Suggested Citation

  • Galo Nuño & Carlos Thomas, 2015. "Monetary policy and sovereign debt vulnerability," Working Papers 1517, Banco de España;Working Papers Homepage.
  • Handle: RePEc:bde:wpaper:1517
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    References listed on IDEAS

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    Cited by:

    1. Illenin Kondo & Fabrizio Perri & Sewon Hur, 2016. "Inflation, Debt, and Default," 2016 Meeting Papers 1610, Society for Economic Dynamics.
    2. Engler, Philipp & Große Steffen, Christoph, 2016. "Sovereign risk, interbank freezes, and aggregate fluctuations," European Economic Review, Elsevier, vol. 87(C), pages 34-61.
    3. Aguiar, M. & Chatterjee, S. & Cole, H. & Stangebye, Z., 2016. "Quantitative Models of Sovereign Debt Crises," Handbook of Macroeconomics, Elsevier.
    4. Ricardo Sabbadini, 2017. "Overcoming the Original Sin: Gains from Local Currency External Debt," Working Papers, Department of Economics 2017_27, University of São Paulo (FEA-USP).
    5. repec:eee:inecon:v:110:y:2018:i:c:p:119-134 is not listed on IDEAS
    6. Bolton, Patrick & Huang, Haizhou, 2017. "The Capital Structure of Nations," CEPR Discussion Papers 12157, C.E.P.R. Discussion Papers.
    7. repec:eee:inecon:v:118:y:2019:i:c:p:31-43 is not listed on IDEAS
    8. Rebelo, Sérgio & Wang, Neng & Yang, Jinqiang, 2018. "Rare Disasters, Financial Development, and Sovereign Debt," CEPR Discussion Papers 13202, C.E.P.R. Discussion Papers.

    More about this item

    Keywords

    monetary-fiscal interactions; discretion; sovereign default; continuous time; optimal stopping;

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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