Working Paper: NBER ID: w20650
Authors: Antoine Camous; Russell Cooper
Abstract: The valuation of government debt is subject to strategic uncertainty, stemming from investors' sentiments. Pessimistic lenders, fearing default, bid down the price of debt. This leaves a government with a higher debt burden, increasing the likelihood of default and thus confirming the pessimism of lenders. This paper studies the interaction of monetary policy and debt fragility. It asks: do monetary interventions mitigate debt fragility? The answer depends in part on the nature of monetary policy, particularly the ability of the monetary authority to commit to future state contingent actions. With commitment to a state contingent policy, the monetary authority can indeed overcome strategic uncertainty. Under discretion, debt fragility remains unless reputation effects are sufficiently strong.
Keywords: monetary policy; seignorage; inflation; sovereign debt; self-fulfilling debt crisis; sunspot equilibria
JEL Codes: E42; E58; E63; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| commitment to a state-contingent policy (E61) | mitigation of debt fragility (F65) |
| commitment to a state-contingent policy (E61) | reduction in strategic uncertainty (D80) |
| reduction in strategic uncertainty (D80) | lower likelihood of default (G33) |
| discretionary monetary policy (E60) | higher default risks (G32) |
| strong reputation effects (D80) | lower default risks under discretion (G33) |
| inflation expectations (E31) | influence on real value of debt (E43) |
| monetary interventions (E52) | debt sustainability (H63) |
| expected inflation (E31) | high inflation equilibrium under discretion (E31) |
| high inflation equilibrium (E31) | complicates government's ability to service debt (H63) |