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

Cristina Arellano, Yan Bai and Gabriel Mihalache ()

Department of Economics Working Papers from Stony Brook University, Department of Economics

Abstract: This paper develops a New Keynesian model with sovereign debt and default. We focus on domestic interest rules governing monetary policy and external foreign currency government debt that is defaultable. Monetary policy and default risk interact as they both impact domestic consumption and production. We find that default risk generates monetary frictions, which amplify the monetary response to shocks. Large sovereign default risk depresses domestic consumption and production. These monetary frictions in turn discipline sovereign borrowing, resulting in slower debt accumulation and lower spreads. Our framework replicates the positive co-movements of sovereign spreads with domestic nominal 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 sovereign spreads. A counterfactual experiment shows that, by raising the domestic rate, the Brazilian central bank not only reduced inflation but also alleviated the debt crisis.

Date: 2019
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
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http://www.stonybrook.edu/commcms/economics/resear ... _NK_default_1902.pdf (application/pdf)

Related works:
Working Paper: Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default) (2020) Downloads
Working Paper: Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default) (2020) Downloads
Working Paper: Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default) (2019) Downloads
Working Paper: Inflation Targeting with Sovereign Default Risk (2019)
Working Paper: Inflation Targeting with Sovereign Default Risk (2018) Downloads
Working Paper: Inflation Targeting with Sovereign Default Risk (2018) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:nys:sunysb:19-02

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