Working Paper: CEPR ID: DP9358
Authors: Giancarlo Corsetti; Luca Dedola
Abstract: Building on Calvo (1988), we develop a stochastic monetary economy in which government default may be driven by either self-fulfilling expectations or weak fundamentals, and explore conditions under which central banks can rule out the former. We analyze monetary backstops resting on the ability of the central bank to swap government debt for its monetary liabilities, whose demand is not undermined by fears of default. To be effective, announced interventions must be credible, i.e., feasible and welfare improving. Absent fundamental default risk, a monetary backstop is always effective in preventing self-fulfilling crises. In the presence of fundamental default risk and institutional constraints on the balance sheet of the central bank, a credible monetary backstop is likely to fall short of covering government's financial needs in full. It is thus effective to the extent that it increases the level of debt below which the equilibrium is unique.
Keywords: debt monetization; 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 |
|---|---|
| credible monetary backstop (E52) | prevent self-fulfilling debt crises (F34) |
| credible monetary backstop (E52) | stabilize market expectations (D84) |
| absence of fundamental default risk (G33) | effectiveness of interventions (I24) |
| credible monetary backstop + fundamental default risk (E44) | effectiveness of backstop is conditional (F55) |
| market expectations (D84) | interest rates (E43) |
| market expectations (D84) | government fiscal choices (E62) |
| fiscal stress + market expectations (E62) | self-fulfilling crises (H12) |