Working Paper: CEPR ID: DP10609
Authors: Philippe Bacchetta; Elena Perazzi; Eric van Wincoop
Abstract: This paper examines quantitatively the potential for monetary policy to avoid self-fulfilling sovereign debt crises. We combine a version of the slow-moving debt crisis model proposed by Lorenzoni and Werning (2014) with a standard New Keynesian model. We consider both conventional and unconventional monetary policy. Under conventional policy the central bank can preclude a debt crisis through inflation, lowering the real interest rate and raising output. These reduce the real value of the outstanding debt and the cost of new borrowing, and increase tax revenues and seigniorage. Unconventional policies take the form of liquidity support or debt buyback policies that raise the monetary base beyond the satiation level. We find that generally the central bank cannot credibly avoid a self-fulfilling debt crisis. Conventional policies needed to avert a crisis require excessive inflation for a sustained period of time. Unconventional monetary policy can only be effective when the economy is at a structural ZLB for a sustained length of time.
Keywords: Long-term debt; Monetary policy; Sovereign debt crises
JEL Codes: E52; E60; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Conventional monetary policy lowers real interest rates (E43) | Reduces real value of outstanding debt (G32) |
| Conventional monetary policy raises output (E52) | Reduces real value of outstanding debt (G32) |
| Sustained excessive inflation (E31) | Required to maintain conventional monetary policy (E52) |
| Unconventional monetary policy effective at structural zero lower bound (E52) | Prevents self-fulfilling crisis (H12) |
| Aggressive monetary policy must be credible and sustainable (E63) | Prevents self-fulfilling crisis (H12) |
| Central banks cannot credibly avoid a self-fulfilling debt crisis (F65) | Incurs significant costs (G32) |