Revisiting the Fiscal Theory of Sovereign Risk from a DSGE Viewpoint

In this study, we revisit Uribe's (2006, Journal of Monetary Economics) `fiscal theory of sovereign risk,' which suggests a trade-off between stabilizing inflation and suppressing default. Unlike Uribe (2006), we develop a class of dynamic stochastic general equilibrium models in which the production is endogenous with nominal rigidities, but where the default mechanism follows Uribe (2006). This marginal change generates a new Keynesian Phillips curve which connects inflation and the output gap. Under the optimal monetary and fiscal (OMF) policy, the nominal interest rate and tax rate are both used as policy instruments. A change in tax rate stabilizes inflation by stabilizing the output gap. Further, this change in tax rate also stabilizes fiscal surplus. Therefore, a trade-off between stabilizing inflation and suppressing the default is mitigated by the OMF policy. Notice that the OMF policy is a de fact inflation stabilization policy so that the tax rate is viewed as a policy instrument assigned to stabilize inflation