DP16837 Fear of Hiking? Monetary Policy and Sovereign Risk

Author(s): Martin Wolf, Leopold Zessner-Spitzenberg
Publication Date: December 2021
Keyword(s): Currency Union, monetary policy, monetary- fiscal interaction, Sovereign debt, sovereign debt crisis, sovereign default, Spreads
JEL(s): E52, F34, F41
Programme Areas: International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16837

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.