Discretionary monetary and fiscal policy with endogenous sovereign risk

Joost Roettger

Journal of Economic Dynamics and Control, 2019, vol. 105, issue C, 44-66

Abstract: How does the presence of sovereign risk affect the conduct of public policy? To answer this question, this paper studies optimal monetary and fiscal policy without commitment for a model economy with nominal public debt and strategic sovereign default. Compared to an economy without the possibility of default, economies with sovereign risk experience more volatile interest rates, which impedes the government’s ability to smooth tax rates across states. Risk of default also limits public debt accumulation, reducing the government’s incentive to use surprise inflation on average. When calibrated to the United States, the model predicts that a counterfactual increase in the average annual default probability from 0 to 1% lowers average inflation by 33%, raises the standard deviation of inflation by 18% and increases the standard deviation of the labor income tax by 73%. The transmission of exogenous shocks to real aggregate quantities is however almost unaffected by the possibility of default. For example, the presence of sovereign risk would increase the standard deviation of log real GDP by less than 1% in the experiment above. Similarly, the welfare consequences of sovereign risk are found to be of negligible size as well.

Keywords: Optimal monetary and fiscal policy; Discretion; Public debt; Sovereign default (search for similar items in EconPapers)
JEL-codes: E31 E63 H63 (search for similar items in EconPapers)
Date: 2019
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0165188919300892
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:105:y:2019:i:c:p:44-66

DOI: 10.1016/j.jedc.2019.05.010

Access Statistics for this article

Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok

More articles in Journal of Economic Dynamics and Control from Elsevier
Bibliographic data for series maintained by Catherine Liu ().