Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default)

Cristina Arellano, Yan Bai and Gabriel Mihalache

No 26671, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper develops a New Keynesian model with sovereign default risk. Inflation is set by forward-looking firms, monetary policy is an interest rate rule, and the fiscal government borrows externally, long-term, with an option to default. In this framework, default risk creates inflation pressures through an expectations channel, and tight monetary policy disincentivizes fiscal overborrowing. The model sheds light on temporary inflation events in emerging market data, short-lived spikes in inflation, spreads, and domestic policy rates. As spreads rise, firms increase their prices in expectation of higher future inflation during defaults. Monetary policy tightens, which reduces inflation and helps bring spreads down by disciplining government borrowing. These monetary-fiscal interactions imply that delivering the flexible price allocation may not be optimal for monetary policy.

JEL-codes: E52 F34 F41 (search for similar items in EconPapers)
Date: 2020-01
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
Note: EFG IFM ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

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Related works:
Working Paper: Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default) (2020)
Working Paper: Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default) (2019)
Working Paper: Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default) (2019)
Working Paper: Inflation Targeting with Sovereign Default Risk (2018)
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