Working Paper: CEPR ID: DP11089
Authors: Giancarlo Corsetti; Luca Dedola
Abstract: We study the conditions under which unconventional (balance-sheet)monetary policy can rule out self-fulfilling sovereign default in a model with optimizing but discretionary fiscal and monetary policymakers. When purchasing sovereign debt, the central bank effectively swaps risky government paper for monetary liabilities only exposed to inflation risk, thus yielding a lower interest rate. As central bank purchases reduce the (ex ante) costs of debt, we characterize a critical threshold beyond which, absent fundamental fiscal stress, the government strictly prefers primary surplus adjustment to default. Because default may still occur for fundamental reasons, however, the central bank faces the risk of losses on sovereign debt holdings, which may generate inefficient inflation. We show that these losses do not necessarily undermine the credibility of a backstop, nor the monetary authorities? ability to pursue its inflation objectives. Backstops are credible if either the central bank enjoys fiscal backing or fiscal authorities are sufficiently averse to inflation.
Keywords: Inflationary Financing; Lender of Last Resort; Seigniorage; Sovereign Risk; Default
JEL Codes: E58; E63; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Central bank purchases of government bonds (E58) | Lower interest rates on sovereign debt (E43) |
| Lower interest rates on sovereign debt (E43) | Reduced costs of debt servicing (F34) |
| Reduced costs of debt servicing (F34) | Preference for fiscal adjustments over default (E62) |
| Fiscal authority backing to the central bank (E58) | Maintained credibility of the backstop (E61) |
| Maintained credibility of the backstop (E61) | Effective pursuit of inflation objectives by the central bank (E52) |
| Strict budget separation (H61) | Complicated fiscal authority decisions (E62) |
| Adverse realizations of economic fundamentals (F65) | Default may occur (G33) |
| Central bank interventions (E52) | Risk of losses on the central bank's balance sheet (F65) |