Fiscal Limits and Monetary Policy : Default vs. Inflation

In times of fiscal stress, governments fail to adjust fiscal policy in line with the requirements for debt sustainability. Under these circumstances, monetary policy impacts the probability of sovereign default alongside inflation dynamics. Uribe (2006) studies the relationship between inflation and sovereign defaults with a model in which the central bank controls a risky interest rate. He concludes that low inflation can only be maintained if the government sometimes defaults. This paper follows Uribe (2006) by examining monetary policy that controls a risky interest rate. However, it differs by the baseline assumption about the objectives of the central bank. In this paper, monetary policy is not pure inflation targeting: it is assumed that the central bank minimizes the probability of default under the upper restriction on inflation. An advantage of this framework is that it avoids the issue of zero risk premium, which exists in Uribe (2006), while at the same time allowing a study of the relationship between the constraints on monetary policy, the equilibrium default rate, and the risk premium. We show that monetary policy that controls the risky interest rate can mitigate default risks only when the upper limit on inflation is sufficiently high. The higher the agents believe the upper limit on inflation to be, the lower the equilibrium risk premium and probability of default are. Under a low default rate, constraints on inflation can only be fulfilled when fiscal shocks are either positive or small