Sovereign Default and Monetary Policy Tradeoffs

March 6, 2018
By Huixin Bi, Senior Economist , Eric M. Leeper and Campbell Leith


Research Working PaperAs the probability of sovereign default surges, the spread between the risky and risk-free interest rates can force policymakers to choose between stabilizing inflation and stabilizing output.

How do the effects of routine monetary operations designed to achieve macroeconomic stabilization change when the economy moves from a debt to GDP level where the probability of default is nil to the “fiscal limit,” where the default probability is non-negligible? We find that the specification of the monetary policy rule plays a critical role. By targeting the risky rate, the central bank accommodates default risk, amounting to an implicit relaxation in the inflation target as the economy approaches 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 central bank keeps its inflation target unchanged even as sovereign default risk surges. As a result, output endures most of the macroeconomic cost of fiscal adjustment in response to high debt.

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RWP 18-02, March 2018

JEL Classification: H60, E30, E62, H30

Article Citation

  • Bi, Huixin. 2018. “Sovereign Default and Monetary Policy Tradeoffs.” Federal Reserve Bank of Kansas City, Research Working Paper no. 18-02, March. Available at https://doi.org/10.18651/RWP2018-02

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