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Monetary and Fiscal Policy with Sovereign Default


  • Joost Röttger


How does the option to default on debt payments affect the conduct of public policy? To answer this question, this paper studies optimal monetary and fiscal policy without commitment in a model with nominal debt and endogenous sovereign default. When the government can default on its debt, public policy changes in the short and the long run relative to a setting without default option. The risk of default increases the volatility of interest rates, impeding the government's ability to smooth tax distortions across states. It also limits public debt accumulation and reduces the government's incentive to implement high inflation in the long run. The welfare costs associated with the short-run effects of sovereign default are found to be outweighed by the welfare gains due to lower average debt and inflation.

Suggested Citation

  • Joost Röttger, 2014. "Monetary and Fiscal Policy with Sovereign Default," Working Paper Series in Economics 74, University of Cologne, Department of Economics.
  • Handle: RePEc:kls:series:0074

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    References listed on IDEAS

    1. Gabriel Cuadra & Juan Sanchez & Horacio Sapriza, 2010. "Fiscal Policy and Default Risk in Emerging Markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 13(2), pages 452-469, April.
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    More about this item


    Monetary and Fiscal Policy; Lack of Commitment; Sovereign Default; Domestic Debt; Markov-Perfect Equilibrium;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • 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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