Inflation Stabilization and Default Risk in a Currency Union

Eiji Okano (), Masashige Hamano and Pierre Picard

No 28, UTokyo Price Project Working Paper Series from University of Tokyo, Graduate School of Economics

Abstract: By developing a class of dynamic stochastic general equilibrium models with nominal rigidities and assuming a two-country currency union with sovereign risk, we show that there is not necessarily a trade-off between the prevention of default risk and stabilizing inflation. Under optimal monetary and fiscal policy, comprising a de facto inflation stabilization policy, the tax rate as an optimal fiscal policy tool plays an important role in stabilizing inflation, although not completely because of the distorted steady state. Changes in the tax rate to minimize welfare costs via stabilizing inflation then improve the fiscal surplus, and because of this and the incompletely stabilized inflation, the default rate does not increase as much.

Keywords: Sovereign Risk; European Crisis; Optimal Monetary Policy; Fiscal Theory of the Price Level; Currency Union (search for similar items in EconPapers)
JEL-codes: E52 E60 F41 F47 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2014-09
New Economics Papers: this item is included in nep-cba, nep-dge, nep-eec, nep-mac, nep-mon and nep-opm
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Related works:
Journal Article: INFLATION STABILIZATION AND DEFAULT RISK IN A CURRENCY UNION (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:upd:utppwp:028

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