Fiscal Imbalances, Inflation and Sovereign Default Dynamics

The central question this paper seeks to answer is how monetary policy might affect the equilibrium behavior of default and sovereign risk premium. The paper is based on �one-interest-rate� model. Public debt becomes risky due to an active fiscal policy, as in Uribe (2006), reflecting the fiscal authority’s limited ability to control primary surplus. The insolvency problem is due to a string of bad luck (negative shocks affecting primary surplus). But in contrast to Uribe’s results, as the sovereign debt cost increases (which result from weak primary surplus), default becomes anticipated and reflected by a rising country risk premium and default probability. The default is defined as reneging on a contractual agreement and so the decision is set by the fiscal authority. However, conflicting objectives between fiscal and monetary authority play an important role in leading fiscal authority to default on its liabilities. The characteristic of the government policy needed to restore the equilibrium after the default is also analyzed.