Masashige HamanoBack to index

  • Inflation Stabilization and Default Risk in a Currency Union

    Abstract

    By developing a class of dynamic stochastic general equilibrium models with nominal rigidities and assuming a two-country currency union with sovereign risk, we show that there is not necessarily a trade-off between the prevention of default risk and stabilizing inflation. Under optimal monetary and fiscal policy, comprising a de facto inflation stabilization policy, the tax rate as an optimal fiscal policy tool plays an important role in stabilizing inflation, although not completely because of the distorted steady state. Changes in the tax rate to minimize welfare costs via stabilizing inflation then improve the fiscal surplus, and because of this and the incompletely stabilized inflation, the default rate does not increase as much.

    Introduction

    How do we conduct monetary policy in a currency union amid sovereign risk premiums? How do the monetary and fiscal authorities behave in this difficult situation? What clues do we have for removing the trade-off between the prevention of default risk and stabilizing inflation? In this paper, we show that there is not necessarily a trade-off between the prevention of default risk and stabilizing inflation. Policy authorities, namely, the central bank and the government, should without hesitation, conduct optimal monetary and fiscal policies, which is equivalent to stabilizing inflation.

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