Sovereign default and monetary policy tradeoffs

Bi, H., Leeper, E. M. and Leith, C. (2018) Sovereign default and monetary policy tradeoffs. International Journal of Central Banking, 14(3), pp. 289-324.

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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 riskfree 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 puts into sharp relief the tradeoff between inflation and output stabilization.

Item Type:Articles
Glasgow Author(s) Enlighten ID:Leeper, Professor Eric Michael and Leith, Professor Campbell
Authors: Bi, H., Leeper, E. M., and Leith, C.
College/School:College of Social Sciences > Adam Smith Business School > Economics
Journal Name:International Journal of Central Banking
Publisher:Federal Reserve Board
ISSN (Online):1815-7556
Copyright Holders:Copyright © 2018 The Association of the International Journal of Central Banking
First Published:First published in International Journal of Central Banking 14(3):289-324
Publisher Policy:Reproduced in accordance with the copyright policy of the publisher

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