Sovereign Default and the Stability of Inflation-Targeting Regimes

We analyze the impact of interactions between monetary and fiscal policy on macroeconomic stability. We find that in the presence of sovereign default, macroeconomic stability requires monetary policy to be passive if the feedback from debt surprises back to the primary surplus is too weak. An active monetary policy can however only contribute to the stabilization inflation and output, if the primary surplus is increasing in debt with a slope that increases with the default probability. The results are relevant for the design of fiscal and monetary policy in emerging markets where sovereign credibility is not well established. Recent debt developments in Western Europe and in the United States suggest these results may become relevant for more mature financial markets too once the current low inflation period is over.