Working Paper: NBER ID: w10390
Authors: Carlo A. Favero; Francesco Giavazzi
Abstract: Studying the recent experience of Brazil the paper explains how default risk is at the centre of the mechanism through which an emerging market central bank that targets inflation might lose control of inflation--in other words of the mechanism through which the economy might move from a regime of 'monetary dominance' to one of 'fiscal dominance'. The literature, from Sargent and Wallace (1981) to the modern fiscal theory of the price level has discussed how an unsustainable fiscal policy may hinder the effectiveness of monetary policy, to the point that an increase in interest rates can have a perverse effect on inflation. We show that the presence of default risk reinforces the possibility that a vicious circle might arise, making the fiscal constraint on monetary policy more stringent.
Keywords: Inflation targeting; Debt; Brazil
JEL Codes: E4; E6; F3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| default risk (G33) | ineffective monetary policy (E65) |
| unsustainable fiscal policy (E62) | ineffective monetary policy (E65) |
| increase in EMBI spread (F65) | depreciation of exchange rate (F31) |
| depreciation of exchange rate (F31) | raise inflation expectations (E31) |
| raise inflation expectations (E31) | higher interest rates from central bank (E43) |
| higher interest rates (E43) | rising cost of debt service (F34) |
| rising cost of debt service (F34) | exacerbates fiscal situation (E62) |
| fiscal policy regime stability (E63) | less dramatic EMBI spread response (F29) |
| weak fiscal fundamentals (E62) | amplified EMBI spread response to shocks (F65) |