International Debt Overhang and Monetary Policy: A Simulation Exercise Using Czech Republic Data

Abstract

We are concerned with the dangers arising from excessive international debt overhang, primarily to financial stability in the debtor country. Assuming that debt forgiveness is not possible, a subject which we modelled earlier relating to the Greek debt crisis, (Goodhart et al. (2018)), we show how an independent monetary policy can be used to smooth consumption for both borrowers and lenders. A counter-cyclical monetary policy can contract liquidity when debt growth is high and expand liquidity when default rates are high. These results are closely related to the policy debate on monetary policy as a macroprudential policy tool.

Keywords: Debt, Default, Monetary Policy, Renegotiation, Business Cycles, Open Economy

JEL Classification: F34, G15, G18