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The "Mystery of the Printing Press" Monetary Policy and Self-fulfilling Debt Crises

Author

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  • Giancarlo Corsetti

    (Faculty of Economics University of Cambridge)

  • Luca Dedola

    (European Central Bank)

Abstract

Sovereign debt crises may be driven by either self-fulfilling expectations of default or fundamental fiscal stress. This paper studies the mechanisms by which either conventional or unconventional monetary policy can rule out the former. Conventional monetary policy is modeled as a standard choice of inflation, while unconventional policy as outright purchases in the debt market. By intervening in the sovereign debt market, the central bank effectively swaps risky government paper for monetary liabilities only exposed to inflation risk and thus yielding a lower interest rate. We Show that, provided fiscal and monetary authorities share the same objective function, there is a minimum threshold for the size of interventions at which a backstop rules out self-fulfilling default without eliminating the possibility of fundamental default under fiscal stress. Fundamental default risk does not generally undermine the credibility of a backstop, nor does it foreshadow runaway inflation, even when the central bank is held responsible for its own losses.

Suggested Citation

  • Giancarlo Corsetti & Luca Dedola, 2012. "The "Mystery of the Printing Press" Monetary Policy and Self-fulfilling Debt Crises," Discussion Papers 1424, Centre for Macroeconomics (CFM), revised Aug 2014.
  • Handle: RePEc:cfm:wpaper:1424
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    References listed on IDEAS

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    More about this item

    Keywords

    Sovereign Risk and Default; Lender of Last Resort; Seigniorage; Debt Monetization;
    All these keywords.

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • 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
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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