Working Paper: CEPR ID: DP5590
Authors: Andreas Schabert; Sweder van Wijnbergen
Abstract: Blanchard (2005) suggested that active interest rate policy might induce unstable dynamics in highly-indebted economies. We examine this in a dynamic general equilibrium model where Calvo-type price rigidities provide a rationale for inflation stabilization. Unstable dynamics can occur when the CB is aggressively raising the interest rate in response to higher expected inflation. The constraint on stabilizing interest rate policy is tighter the higher the primary deficit and the more open the economy is. If the government cannot borrow from abroad in its own currency, stability requires interest rate policy to be accommodating (passive). Inflation stabilization is nevertheless feasible if the CB uses an instrument not associated with default risk, e.g. money supply.
Keywords: fiscal-monetary policy interactions; foreign debt; inflation targeting; policy implementation; sovereign default risk
JEL Codes: E52; E63; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Aggressive interest rate increases (E43) | destabilize economies with high public debt (F65) |
| Higher interest rates (E43) | increased debt servicing costs (F34) |
| increased debt servicing costs (F34) | fears of default (G33) |
| fears of default (G33) | real depreciation of the currency (F31) |
| real depreciation of the currency (F31) | exacerbates inflation (E31) |
| Passive interest rate policy (E43) | mitigate destabilizing effects (E63) |
| High share of tax financing (H29) | mitigate destabilizing effects (E63) |
| Public debt indexed to foreign currencies (F34) | aggressive interest rate policies lead to instability (E43) |
| Inflation targeting (E31) | effective (C99) |
| Central banks avoiding interest rate rules associated with risk (E49) | crucial (Y60) |