DP5590 Debt, Deficits and Destabilizing Monetary Policy in Open Economies

Author(s): Andreas Schabert, Sweder van Wijnbergen
Publication Date: March 2006
Keyword(s): fiscal-monetary policy interactions, foreign debt, inflation targeting, policy implementation, sovereign default risk
JEL(s): E52, E63, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5590

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.