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Fiscal Imbalances, Inflation and Sovereign Default Dynamics

  • Guillard, Michel
  • Sosa Navarro, Ramiro

The central question this paper seeks to answer is how monetary policy might affect the equilibrium behavior of default and sovereign risk premium. The paper is based on �one-interest-rate� model. Public debt becomes risky due to an active fiscal policy, as in Uribe (2006), reflecting the fiscal authority’s limited ability to control primary surplus. The insolvency problem is due to a string of bad luck (negative shocks affecting primary surplus). But in contrast to Uribe’s results, as the sovereign debt cost increases (which result from weak primary surplus), default becomes anticipated and reflected by a rising country risk premium and default probability. The default is defined as reneging on a contractual agreement and so the decision is set by the fiscal authority. However, conflicting objectives between fiscal and monetary authority play an important role in leading fiscal authority to default on its liabilities. The characteristic of the government policy needed to restore the equilibrium after the default is also analyzed.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 24075.

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Date of creation: Dec 2009
Date of revision:
Handle: RePEc:pra:mprapa:24075
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  1. Bennett T. McCallum, 2001. "Should Monetary Policy Respond Strongly to Output Gaps?," American Economic Review, American Economic Association, vol. 91(2), pages 258-262, May.
  2. Willem Buiter, 2000. "The Fallacy of the Fiscal Theory of the Price Level, Again," CESifo Working Paper Series 303, CESifo Group Munich.
  3. John H. Cochrane, 1999. "Portfolio Advice for a Multifactor World," NBER Working Papers 7170, National Bureau of Economic Research, Inc.
  4. Buiter, Willem H., 1999. "The Fallacy of the Fiscal Theory of the Price Level," CEPR Discussion Papers 2205, C.E.P.R. Discussion Papers.
  5. Marco Arena & Carmen Reinhart & Francisco Vázquez, 2006. "The Lending Channel in Emerging Economics: Are Foreign Banks Different?," NBER Working Papers 12340, National Bureau of Economic Research, Inc.
  6. Uribe, Martin, 2006. "A fiscal theory of sovereign risk," Journal of Monetary Economics, Elsevier, vol. 53(8), pages 1857-1875, November.
  7. 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.
  8. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, vol. 4(3), pages 381-99.
  9. repec:oup:qjecon:v:115:y:2000:i:1:p:147-180 is not listed on IDEAS
  10. 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.
  11. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  12. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, December.
  13. Pau Rabanal, 2004. "Monetary Policy Rules and the U.S. Business Cycle: Evidence and Implications," IMF Working Papers 04/164, International Monetary Fund.
  14. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, vol. 4(3), pages 345-80.
  15. McCallum, Bennett T., 1981. "Price level determinacy with an interest rate policy rule and rational expectations," Journal of Monetary Economics, Elsevier, vol. 8(3), pages 319-329.
  16. Sosa Navarro, Ramiro, 2005. "Default Recovery Rates and Implied Default Probability Estimations: Evidence from the Argentinean Crisis," MPRA Paper 11054, University Library of Munich, Germany.
  17. repec:oup:qjecon:v:117:y:2002:i:2:p:379-408 is not listed on IDEAS
  18. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
  19. repec:oup:qjecon:v:119:y:2004:i:1:p:276-299 is not listed on IDEAS
  20. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-54, April.
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