Monetary Policy under a Fiscal Theory of Sovereign Default

This paper examines equilibrium determination under different monetary policy regimes when the government might default on its debt. We apply a cash-in-advance model where the government does not have access to non-distortionary taxation and does not account for initial outstanding debt when it sets the income tax rate. Solvency is then not guaranteed and sovereign default can affect the return on public debt. If the central bank sets the interest rate in a conventional way, the equilibrium allocation cannot be determined. If, instead, money supply is controlled, the equilibrium allocation can uniquely be determined.