Fiscal and Monetary Policy Coordination, Macroeconomic Stability, and Sovereign Risk

Tinbergen Institute Discussion Paper 2014-006/VI

30 Pages Posted: 7 Jan 2014

See all articles by Dennis Bonam

Dennis Bonam

VU University Amsterdam

Jasper Lukkezen

CPB Netherlands Bureau of Economic Policy Analysis; Utrecht University

Date Written: January 7, 2014

Abstract

In standard macroeconomic models, debt sustainability and price level determinacy are achieved when fiscal policy avoids explosive debt and monetary policy controls inflation, irrespective of the relative strengths of each policy stance. We examine how these policy requirements for equilibrium stability and determinacy change in the presence of sovereign risk. An increase in sovereign risk reduces lender's willingness to hold government debt and raises consumption and inflation. Therefore, inflation and debt dynamics are determined jointly. To ensure stable macroeconomic conditions, both the fiscal and monetary stance must shift to offset debt sustainability concerns. We find that the adoption of a deficit target helps alleviate such concerns and raises the scope for macroeconomic stability.

Keywords: Fiscal and monetary policy coordination, equilibrium determinacy and stability, sovereign risk, policy rules

JEL Classification: E52, E62, E63

Suggested Citation

Bonam, Dennis and Lukkezen, Jasper, Fiscal and Monetary Policy Coordination, Macroeconomic Stability, and Sovereign Risk (January 7, 2014). Tinbergen Institute Discussion Paper 2014-006/VI, Available at SSRN: https://ssrn.com/abstract=2375621 or http://dx.doi.org/10.2139/ssrn.2375621

Dennis Bonam (Contact Author)

VU University Amsterdam ( email )

De Boelelaan 1105
Amsterdam, ND North Holland 1081 HV
Netherlands

Jasper Lukkezen

CPB Netherlands Bureau of Economic Policy Analysis ( email )

P.O. Box 80510
2508 GM The Hague, 2585 JR
Netherlands

Utrecht University ( email )

Vredenburg 138
Utrecht, 3511 BG
Netherlands

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