Series: Working Papers. 1517.
Author: Galo Nuño and Carlos Thomas.
Topics: Government debt | Monetary policy | Quantitative methods | Prices and margins | Inflation | Crisis.
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Abstract
We investigate the trade-offs between price stability and the sustainability of sovereign debt, using a small open economy model where the government issues nominal defaultable debt and chooses fiscal and monetary policy under discretion. When choosing inflation, the government trades off the reduction in the real value of debt -which makes it more sustainable- against the welfare costs of inflation. We compare this scenario with one in which the government gives up the ability to deflate debt away, e.g. by issuing foreign currency debt or joining a monetary union with an anti-inflationary stance. We find that the benefits of abandoning debt deflation outweigh the costs, even when the economy is close to default. Crucially, the increase in inflation expectations and hence in nominal yields produced by discretionary monetary policy largely undoes the debt deflation effect.