Fiscal limits and monetary policy: default vs. inflation

a r t i c l e i n f o This paper studies the monetary policy trade-off between low inflation and low sovereign risk in the environment where fiscal authorities fail to fully ensure the sustainability of government debt. Building on the Fiscal Theory of Price Level (FTPL) and the Fiscal Theory of Sovereign Risk (FTSR), this paper differs in its baseline assumption about the monetary policy objective, which is neither to rule out defaults regardless of inflation costs (as in FTPL), nor to follow inflation targeting regardless of associated sovereign risk (as in FTSR). Instead, we study the case in which the central bank controls the risky interest rate to minimize the probability of default while ruling out large inflation hikes. We show that this policy regime can mitigate default risks only when the central bank is expected to allow sufficient increases in inflation. When agents believe that the central bank's tolerance toward inflation hikes has increased, equilibrium risk premium goes down, suggesting that information concerning changes in the central bank's preferences over inflation directly impacts default risks. In the aftermath of 2007–2008 crisis, some economies of the European Monetary Union (EMU) have found themselves in a complex situation. On the one hand, there is a pressing need to increase budget surpluses to mitigate default risks; on the other hand, the scope of raising extra revenues through fiscal austerity is limited because such policy may lead to further recession and cause political crises. In the presence of fiscal stress, fiscal policy by itself may fail to ensure the sustainability of government debt. In this environment, it is crucial to learn what the monetary policy controlling the costs of borrowing can do to mitigate the debt crisis. Sovereign defaults have devastating consequences for the financial system. Ensuring the stability of the financial system is one of the key functions of a central bank. When government debt is denominated in national currency, the central bank is capable of resolving debt sustainability issues by causing the costs of debt servicing to be reduced. Uribe (2006) shows that in the presence of sovereign default risks, two fundamental functions of the central bank are in conflict: ensuring debt sustainability (stability of the financial system) and maintaining low inflation. In the literature studying default risks and monetary policy , authors often presuppose that one of the two aims of the central bank is dominant; …