Monetary Policy and Sovereign Risk in Emerging Economies (Nk-Default)

67 Pages Posted: 22 Jan 2020 Last revised: 18 May 2022

See all articles by Cristina Arellano

Cristina Arellano

Federal Reserve Bank of Minneapolis

Yan Bai

University of Rochester - Department of Economics

Gabriel Mihalache

Stony Brook University

Date Written: January 2020

Abstract

This paper develops a New Keynesian model with sovereign default risk (NK-Default). We focus on the interaction between monetary policy, conducted according to an interest rate rule that targets inflation, and external defaultable debt issued by the government. Monetary policy and default risk interact since both affect domestic consumption, production, and inflation. We find that default risk amplifies monetary frictions and generates a tension for monetary policy, which increases the volatility of inflation and nominal rates. These monetary frictions in turn discipline sovereign borrowing, slowing down debt accumulation and lowering sovereign spreads. Our framework replicates the positive comovements of spreads with nominal domestic rates and inflation, a salient feature of emerging markets data, and can rationalize the experience of Brazil during the 2015 downturn, with high inflation, nominal rates, and spreads.

Suggested Citation

Arellano, Cristina and Bai, Yan and Mihalache, Gabriel, Monetary Policy and Sovereign Risk in Emerging Economies (Nk-Default) (January 2020). NBER Working Paper No. w26671, Available at SSRN: https://ssrn.com/abstract=3522320

Cristina Arellano (Contact Author)

Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

Yan Bai

University of Rochester - Department of Economics ( email )

Harkness Hall
Rochester, NY 14627
United States

Gabriel Mihalache

Stony Brook University ( email )

SBS S633
Stony Brook, NY NY 11794
United States

HOME PAGE: http://www.gmihalache.com/

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