Debt Sustainability with Conventional and Unconventional Monetary Policy

Abstract

We embed a macro-monetary model into stochastic debt sustainability analysis with optimal debt financing maturities and endogenous risk premia responding to central bank asset purchases. We model the impact on debt dynamics of unconventional monetary policies through asset purchases, of the conventional monetary policy rate response to inflation shocks, and their interaction. We apply the model to comprehensively assess the European Central Bank’s pandemic emergency purchase program (PEPP). We find that the program’s positive effect on debt sustainability persists beyond the end of the program, with the program termination putting upward pressure on spreads but debt remaining below the pre-pandemic levels; inflation surprises can have an indirect unfavorable impact if the inflation shock prompts earlier program termination; the program induces a lengthening of maturities, with the optimal debt financing response closely matching the empirically observed lengthening of maturities in the eurozone. These findings uncover a novel channel of fiscal-monetary interaction through unconventional monetary policy effects on public debt in bad times. A retrospective analysis of the Bank of Japan’s quantitative and qualitative easing demonstrates the model’s generality and obtains results aligned with the PEPP.

Keywords: Debt sustainability analysis, risk management, unconventional monetary policy, monetary-fiscal mix, PEPP, CVaR optimization, Japanese debt

JEL Classification: E52, H63, H68