Discussion Paper Details

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Title: Fear of Hiking? Monetary Policy and Sovereign Risk

Author(s): Martin Wolf and Leopold Zessner-Spitzenberg

Publication Date: December 2021

Keyword(s): Currency Union, monetary fiscal interaction, monetary policy, Sovereign debt, sovereign default and Spreads

Programme Area(s): International Macroeconomics and Finance and Monetary Economics and Fluctuations

Abstract: What are the implications of a rise in interest rates by the central bank of a monetary union for sovereign borrowing decisions and sovereign default risk in a union member? We study this question in a quantitative sovereign default model and obtain two results. First, the sovereign's incentives to borrow following a monetary tightening are shaped by two competing effects, a positive income and a negative substitution effect. Second, a critical threshold for debt to GDP exists above which the income effect is dominant, implying that a monetary tightening increases debt levels and the risk of a sovereign default. We quantify this "Fear of Hiking" zone and study its business cycle properties in an application of the model to the euro area.

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Bibliographic Reference

Wolf, M and Zessner-Spitzenberg, L. 2021. 'Fear of Hiking? Monetary Policy and Sovereign Risk'. London, Centre for Economic Policy Research.