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Debt stabilization and financial stability in a monetary union: Market versus authority‐based preventive solutions

Christos Mavrodimitrakis

International Journal of Finance & Economics, 2022, vol. 27, issue 2, 2582-2599

Abstract: Is a debt‐concerned monetary authority desirable? This article deals with the impact of fiscal‐monetary policy interactions in a monetary union on country‐specific and union‐wide debt stabilization, when the authorities act strategically. The focus is on the impact that monetary policy would have on a debt‐concerned fiscal authority through the debt constraint and the corresponding interaction with decentralized fiscal policies. It is shown that the fiscal‐monetary (overall) policy coordination strategic regime delivers better results than the non‐cooperative regime for both the output gap and the outstanding level of debt at the union level. Two further institutional arrangements are investigated and compared: An authority‐based preventive procedure, which works through a debt‐concerned monetary authority, and a market‐based one, which works through financial markets by assuming a risk premium on country‐specific nominal interest rates according to the country‐specific fiscal stances. The risk premium acts as a form of ‘market‐based’ discipline. Both regimes stand between the decentralized and the centralized setting. The central bank's optimal weight on union‐wide debt stabilization is computed when financial markets provide discipline to the fiscal authorities. It is optimal for the social planner to appoint a debt‐concerned central banker, if there is a degree of conservatism from the monetary authority, and/or if the social planner cares about union‐wide debt stabilization. A higher risk premium parameter enhances the impact of the former on the optimal weight on union‐wide debt stabilization, while it reduces the impact of the latter.

Date: 2022
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Handle: RePEc:wly:ijfiec:v:27:y:2022:i:2:p:2582-2599