Domestic Policies and Sovereign Default

A model with two essential elements—sovereign default and distortionary fiscal and monetary policies—explains the interaction between sovereign debt, default risk, and inflation in emerging countries.

A model with two essential elements—sovereign default and distortionary fiscal and monetary policies—explains the interaction between sovereign debt, default risk, and inflation in emerging countries. We derive conditions under which monetary policy is actively used to support fiscal policy and characterize the intertemporal trade-offs that determine the choice of debt. We show that in response to adverse shocks to the terms of trade or productivity, governments reduce debt and deficits and increase inflation and currency depreciation rates, matching the patterns observed in the data for emerging economies. (JEL E31, E52, E62, F34, F41, H63, O23)