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Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default)

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  • Cristina Arellano
  • Yan Bai
  • Gabriel Mihalache

Abstract

This paper develops a New Keynesian model with sovereign default risk (NK-Default). We focus on the interaction between monetary policy, conducted according to an interest rate rule that targets inflation, and external defaultable debt issued by the government. Monetary policy and default risk interact since both affect domestic consumption, production, and inflation. We find that default risk amplifies monetary frictions and generates a tension for monetary policy, which increases the volatility of inflation and nominal rates. These monetary frictions in turn discipline sovereign borrowing, slowing down debt accumulation and lowering sovereign spreads. Our framework replicates the positive comovements of spreads with nominal domestic rates and inflation, a salient feature of emerging markets data, and can rationalize the experience of Brazil during the 2015 downturn, with high inflation, nominal rates, and spreads.

Suggested Citation

  • Cristina Arellano & Yan Bai & Gabriel Mihalache, 2020. "Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default)," Department of Economics Working Papers 19-02-rev1, Stony Brook University, Department of Economics.
  • Handle: RePEc:nys:sunysb:19-02-rev1
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    References listed on IDEAS

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    Cited by:

    1. Drechsel, Thomas & McLeay, Michael & Tenreyro, Silvana, 2019. "Monetary policy for commodity booms and busts," CEPR Discussion Papers 14030, C.E.P.R. Discussion Papers.

    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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