NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Monetary Policy and Debt Fragility

Russell Cooper, Antoine Camous

NBER Working Paper No. 20650
Issued in October 2014, Revised in July 2015
NBER Program(s):   EFG

The valuation of government debt is subject to strategic uncertainty, stemming from investors' sentiments. Pessimistic lenders, fearing default, bid down the price of debt. This leaves a government with a higher debt burden, increasing the likelihood of default and thus confirming the pessimism of lenders. This paper studies the interaction of monetary policy and debt fragility. It asks: do monetary interventions mitigate debt fragility? The answer depends in part on the nature of monetary policy, particularly the ability of the monetary authority to commit to future state contingent actions. With commitment to a state contingent policy, the monetary authority can indeed overcome strategic uncertainty. Under discretion, debt fragility remains unless reputation effects are sufficiently strong.

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Document Object Identifier (DOI): 10.3386/w20650

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