DP10609 Self-Fulfilling Debt Crises: Can Monetary Policy Really Help?

Author(s): Philippe Bacchetta, Elena Perazzi, Eric van Wincoop
Publication Date: May 2015
Keyword(s): long-term debt, Monetary policy, Sovereign debt crises
JEL(s): e52, E60, F34
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10609

This paper examines quantitatively the potential for monetary policy to avoid self-fulfilling sovereign debt crises. We combine a version of the slow-moving debt crisis model proposed by Lorenzoni and Werning (2014) with a standard New Keynesian model. We consider both conventional and unconventional monetary policy. Under conventional policy the central bank can preclude a debt crisis through inflation, lowering the real interest rate and raising output. These reduce the real value of the outstanding debt and the cost of new borrowing, and increase tax revenues and seigniorage. Unconventional policies take the form of liquidity support or debt buyback policies that raise the monetary base beyond the satiation level. We find that generally the central bank cannot credibly avoid a self-fulfilling debt crisis. Conventional policies needed to avert a crisis require excessive inflation for a sustained period of time. Unconventional monetary policy can only be effective when the economy is at a structural ZLB for a sustained length of time.