Sovereign Default and Monetary Policy Tradeoffs

Huixin Bi, Eric Leeper and Campbell Leith
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Huixin Bi: Federal Reserve Bank of Kansas City

International Journal of Central Banking, 2018, vol. 14, issue 3, 289-324

Abstract: The paper is organized around the following question: when the economy moves from a debt-GDP level where the probability of default is nil to a higher level—the “fiscal limit”—where the default probability is non-negligible, how do the effects of routine monetary operations designed to achieve macroeconomic stabilization change? We find that the specification of the monetary policy rule plays a critical role. Consider a central bank that targets the risky rate. When the economy is near its fiscal limit, a transitory monetary policy contraction leads to a sustained rise in inflation, even though monetary policy actively targets inflation and fiscal policy passively adjusts taxes to stabilize debt. If the central bank targets the riskfree rate, on the other hand, the same transitory monetary contraction keeps inflation under control but leads output to contract for a prolonged period of time. The comparison shows that sovereign default risk puts into sharp relief the tradeoff between inflation and output stabilization.

JEL-codes: E30 E62 H30 H60 (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (9)

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Persistent link: https://EconPapers.repec.org/RePEc:ijc:ijcjou:y:2018:q:2:a:6

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