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Title: Debt, Deficits and Destabilizing Monetary Policy in Open Economies

Author(s): Andreas Schabert and Sweder van Wijnbergen

Publication Date: March 2006

Keyword(s): fiscal-monetary policy interactions, foreign debt, inflation targeting, policy implementation and sovereign default risk

Programme Area(s): International Macroeconomics

Abstract: Blanchard (2005) suggested that active interest rate policy might induce unstable dynamics in highly-indebted economies. We examine this in a dynamic general equilibrium model where Calvo-type price rigidities provide a rationale for inflation stabilization. Unstable dynamics can occur when the CB is aggressively raising the interest rate in response to higher expected inflation. The constraint on stabilizing interest rate policy is tighter the higher the primary deficit and the more open the economy is. If the government cannot borrow from abroad in its own currency, stability requires interest rate policy to be accommodating (passive). Inflation stabilization is nevertheless feasible if the CB uses an instrument not associated with default risk, e.g. money supply.

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Bibliographic Reference

Schabert, A and van Wijnbergen, S. 2006. 'Debt, Deficits and Destabilizing Monetary Policy in Open Economies'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=5590