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Fiscal Limits and Monetary Policy: Default vs. Inflation

  • Anna Sokolova

    ()

    (National Research University - Higher School of Economics, Myasnitskaya Street, 20, Moscow, Russia, 101000.)

In times of fiscal stress, governments fail to adjust fiscal policy in line with the requirements for debt sustainability. Under these circumstances, monetary policy impacts the probability of sovereign default alongside inflation dynamics. Uribe (2006) studies the relationship between inflation and sovereign defaults with a model in which the central bank controls a risky interest rate. He concludes that low inflation can only be maintained if the government sometimes defaults. This paper follows Uribe (2006) by examining monetary policy that controls a risky interest rate. However, it differs by the baseline assumption about the objectives of the central bank. In this paper, monetary policy is not pure inflation targeting: it is assumed that the central bank minimizes the probability of default under the upper restriction on inflation. An advantage of this framework is that it avoids the issue of zero risk premium, which exists in Uribe (2006), while at the same time allowing a study of the relationship between the constraints on monetary pol icy, the equilibrium default rate, and the risk premium. We show that monetary policy that controls the risky interest rate can mitigate default risks only when the upper limit on inflation is sufficiently high. The higher the agents believe the upper limit on inflation to be, the lower the equilibrium risk premium and probability of default are. Under a low default rate, constraints on inflation can only be fulfilled when fiscal shocks are either positive or small.

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Paper provided by National Research University Higher School of Economics in its series HSE Working papers with number WP BRP 39/EC/2013.

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Length: 30 pages
Date of creation: 2013
Date of revision:
Publication status: Published in WP BRP Series: Economics / EC, November 2013, pages 1-30
Handle: RePEc:hig:wpaper:39/ec/2013
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  1. Huixin Bi & Eric M. Leeper & Campbell Leith, 2012. "Uncertain Fiscal Consolidations," Working Papers 2012_03, Business School - Economics, University of Glasgow.
  2. Huixin Bi, 2011. "Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy," Working Papers 11-10, Bank of Canada.
  3. Mathias Trabandt & Harald Uhlig, 2006. "How Far Are We From The Slippery Slope? The Laffer Curve Revisited," SFB 649 Discussion Papers SFB649DP2006-023, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  4. Huixin Bi & Nora Traum, 2012. "Estimating Sovereign Default Risk," American Economic Review, American Economic Association, vol. 102(3), pages 161-66, May.
  5. Uribe, Martín, 2002. "A fiscal theory of sovereign risk," Working Paper Series 0187, European Central Bank.
  6. PEKARSKI, Sergei, 2008. "Budget deficits and inflation feedback," CORE Discussion Papers 2008054, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  7. John H. Cochrane, 1998. "Long-term Debt and Optimal Policy in the Fiscal Theory of the Price Level," CRSP working papers 478, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  8. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  9. Michel Guillard & Hubert Kempf, 2012. "L'insoutenable dynamique de la dette. Une analyse macroéconomique du défaut souverain," Revue d'économie politique, Dalloz, vol. 122(6), pages 921-941.
  10. Cooper, Russell & Kempf, Hubert & Peled, Dan, 2010. "Regional debt in monetary unions: Is it inflationary?," European Economic Review, Elsevier, vol. 54(3), pages 345-358, April.
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  12. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
  13. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  14. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  15. International Monetary Fund, 2009. "Fiscal Implications of the Global Economic and Financial Crisis," IMF Staff Position Notes 2009/13, International Monetary Fund.
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  17. Hubert Kempf & Russell Cooper & Dan Peled, 2010. "Regional Debt in Monetary Unions: Is it Inflationary?," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00468945, HAL.
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  19. Woodford, Michael, 1995. "Price-level determinacy without control of a monetary aggregate," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 43(1), pages 1-46, December.
  20. Schabert, Andreas, 2010. "Monetary policy under a fiscal theory of sovereign default," Journal of Economic Theory, Elsevier, vol. 145(2), pages 860-868, March.
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