Sovereign Default and Monetary Policy Tradeoffs

Bi, Huixin; Leeper, Eric M.; Leith, Campbell

Working Paper

Sovereign Default and Monetary Policy Tradeoffs

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 risk-free 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 put into sharp relief the tradeoff between inflation and output stabilization.

Keywords: Fiscal Sustainability; Sovereign Debt Default; Fiscal Limit;

JEL Classification: E30; E62; H30; H60;