Department of Economics
European University Institute
Via della Piazzuola, 43
50133 Firenze, Italy
NBER Working Papers and Publications
|October 2014||Monetary Policy and Debt Fragility|
with Russell Cooper: w20650
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 stro...