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Sovereign Default and Monetary Policy Tradeoffs

Author

Listed:
  • Huixin Bi
  • Eric M. Leeper
  • Campbell Leith

Abstract

The paper is organized around the following question: when the economy moves from a debt-GDP level where the probability of default is nil to a higher level?the ?fiscal limit?? where the default probability is non-negligible, how do the effects of routine monetary operations designed to achieve macroeconomic stabilization change? We find that the specification of the monetary policy rule plays a critical role. Consider a central bank that targets the risky rate. When the economy is near its fiscal limit, a transitory monetary policy contraction leads to a sustained rise in inflation, even though monetary policy actively targets inflation and fiscal policy passively adjusts taxes to stabilize debt. If the central bank targets the risk-free rate, on the other hand, the same transitory monetary contraction keeps inflation under control, but leads output to contract for a prolonged period of time. The comparison shows that sovereign default risk put into sharp relief the tradeoff between inflation and output stabilization.

Suggested Citation

  • Huixin Bi & Eric M. Leeper & Campbell Leith, 2018. "Sovereign Default and Monetary Policy Tradeoffs," Research Working Paper RWP 18-2, Federal Reserve Bank of Kansas City, revised 02 Mar 2018.
  • Handle: RePEc:fip:fedkrw:rwp18-02
    DOI: 10.18651/RWP2018-02
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    File URL: https://doi.org/10.18651/RWP2018-02
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    Cited by:

    1. Javier Andrés & Pablo Burriel & Wenyi Shen, 2020. "Debt sustainability and fiscal space in a heterogeneous Monetary Union: normal times vs the zero lower bound," Working Papers 2001, Banco de España;Working Papers Homepage.
    2. Battistini, Niccolò & Callegari, Giovanni & Zavalloni, Luca, 2019. "Dynamic fiscal limits and monetary-fiscal policy interactions," Working Paper Series 2268, European Central Bank.

    More about this item

    Keywords

    Sovereign Debt Default; Fiscal Sustainability; Fiscal Limit;

    JEL classification:

    • H60 - Public Economics - - National Budget, Deficit, and Debt - - - General
    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)

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