Abstract
We study the mechanism by which unconventional (balance-sheet) monetary policy can rule out self-fulfilling sovereign default in a model with optimizing but discretionary fiscal and monetary policymakers. By purchasing sovereign debt, the central bank e§ectively swaps risky government paper for monetary liabilities only exposed to inflation risk, thus yielding a lower interest rate. We characterize a critical threshold for central bank purchases beyond which, absent fundamental fiscal stress, the government strictly prefers primary surplus adjustment to default. Since default may still occur for fundamental reasons, however, the central bank faces the risk of losses on sovereign debt holdings, which may generate ine¢cient inflation. This risk does not undermine the credibility of a backstop, nor the ability of a central bank to pursue its inflation objectives when the latter enjoys fiscal backing or fiscal authorities are su¢ciently averse to inflation.
Highlights
The sovereign debt crisis in the euro area and the launch of the Outright Monetary Transactions (OMTs) program by the European Central Bank (ECB) in September 2012 have revived the debate on the role of monetary policy in shielding a country from belief-driven speculation in the sovereign debt market.[1]
We show that conventional monetary policy may enable a central bank to a¤ect the range of debt over which the economy is vulnerable to beliefdriven default, but is generally insu¢ cient to eliminate multiplicity— a point stressed by Aguiar, Amador, Farhi and Gopinath (2015) and Cooper and Camous (2014).[3]
We show that, conditional on market investors requiring a high interest rate to ...nance the government driven by expectations of default not justi...ed by fundamentals, there is a minimum scale of central bank interventions at which outright default becomes a welfare-dominated option and is avoided by ...scal policymakers
Summary
The sovereign debt crisis in the euro area and the launch of the Outright Monetary Transactions (OMTs) program by the European Central Bank (ECB) in September 2012 have revived the debate on the role of monetary policy in shielding a country from belief-driven speculation in the sovereign debt market.[1]. Default can occur via haircuts and/or in‡ationary debt debasement.[2] In addition to pursuing (conventional) in‡ation policy, monetary authorities can engage in (unconventional) balance sheet policy, through outright purchases of government bonds. Even if a backstop policy is successful to rule out belief-driven crises, default may still occur ex-post due to adverse realizations of the fundamentals— raising the risk of losses on the central bank balance sheet.[5] To the extent that these losses make it impossible for the central bank to honor its own liabilities without deviating substantially from its optimal in‡ation plans, monetary authorities become reluctant to intervene ex ante. Perazzi and Van Wincoop (2015) introduce the sovereign default model of Lorenzoni and Werning (2014) in a new-Keynesian framework with short- and long-term debt and exogenous monetary and ...scal rules These authors, like us, study conventional and unconventional (balance sheet) monetary policy— in analyzing the latter, they focus exclusively on the case of zero interest rate policies. As in Calvo (1988), we study the mechanism by which, given the government ...nancing needs, outright default is precipitated by agents’expectations, and develop our analysis in a two-period economy framework
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