Inflation Targeting with Sovereign Default Risk

Cristina Arellano, Gabriel Mihalache and Yan Bai

No 239, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: Since the early 2000s, many emerging markets have adopted inflation targeting as their monetary policy, against a background of recurring sovereign debt crises. We develop a framework that integrates inflation targeting monetary policy with sovereign default risk and identify important interactions. Monetary policy alters incentives for international borrowing and sovereign default risk leads to more volatile nominal interest rates, needed to target inflation. We show that this framework replicates the positive co-movements of sovereign interest rate spreads with domestic nominal rates and inflation, a salient feature of emerging markets data. Our framework rationalizes the experience of Brazil during the 2015 downturn, which featured high inflation, high nominal rates, and high sovereign spreads. Our counterfactual experiment suggests that by raising the domestic rate the Brazilian central bank not only reduced inflation but also alleviated the debt crisis.

Date: 2019
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Related works:
Working Paper: Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default) (2019)
Working Paper: Inflation Targeting with Sovereign Default Risk (2018)
Working Paper: Inflation Targeting with Sovereign Default Risk (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed019:239

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