Working Paper: NBER ID: w26671
Authors: Cristina Arellano; Yan Bai; Gabriel P. Mihalache
Abstract: This paper develops a New Keynesian model with sovereign default risk. Inflation is set by forward-looking firms, monetary policy is an interest rate rule, and the fiscal government borrows externally, long-term, with an option to default. In this framework, default risk creates inflation pressures through an expectations channel, and tight monetary policy disincentivizes fiscal overborrowing. The model sheds light on temporary inflation events in emerging market data, short-lived spikes in inflation, spreads, and domestic policy rates. As spreads rise, firms increase their prices in expectation of higher future inflation during defaults. Monetary policy tightens, which reduces inflation and helps bring spreads down by disciplining government borrowing. These monetary-fiscal interactions imply that delivering the flexible price allocation may not be optimal for monetary policy.
Keywords: Monetary Policy; Sovereign Risk; Emerging Economies; Inflation; Default Risk
JEL Codes: E52; F34; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| sovereign risk (F34) | inflation (E31) |
| tight monetary policy (E52) | default risk (G33) |
| tight monetary policy (E52) | inflation (E31) |
| monetary policy shocks (E39) | sovereign spreads (H63) |