Sovereign Risk and Monetary Policy

In times of fiscal stress monetary policy impacts the probability of sovereign default alongside inflation dynamics. (Uribe, 2006) studies monetary policy that conducts inflation targeting controlling the risky interest rate; he concludes that in the presence of fiscal stress low inflation can only be maintained if the government sometimes defaults. This paper follows (Uribe, 2006) by examining monetary policy that controls the risky interest rate; however, unlike in (Uribe, 2006), in this paper the central bank minimizes the probability of default under the upper restriction on inflation. This framework avoids the issue of zero risk premium that exists in (Uribe, 2006), while at the same time allowing a study of the relationship between the constraints on the monetary policy, the equilibrium default rate and the risk premium. We show that monetary policy that controls the risky interest rate can mitigate default risks only when the upper limit on inflation is sufficiently high. The higher agents believe the upper limit on inflation to be, the lower are equilibrium risk premium and probability of default.