Post on 16-Oct-2020
Monetary Conservatism and Sovereign Default
Joost RöttgerUniversity of Cologne
Fiscal Sustainability, XXI Century
June 8th, 2016
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Overview
1. Introduction2. Model
3. Quantitative Analysis
4. Summary
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MotivationMonetary policy and lack of commitment
I Nominal public debt:I A government faces temptation to relax its budget via surprisein�ation.
I Discretionary policy:I In�ation bias relative to optimal policy under commitment.
I Solution proposed by Rogo¤ (1985):I Delegate monetary policy to a monetary conservative centralbanker.
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MotivationMonetary policy in practice
I Most developed economies have delegated monetary policy toindependent central banks with a focus on price stability.
I Many emerging economies have also recently introducedindependent central banks (see e.g. Carstens and Jácome,2005).
I However, these countries often face frictions that mightundermine the success of such reforms.
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Topic of this paper
Evaluate monetary conservatism when an economy is subject tothree particular frictions:
I Incomplete �nancial marketsI Lack of commitment to debt repaymentI Political economy distortions
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Model environment
I Small open economy as in Arellano (2008)I The economy�s government consists of
I a present-biased �scal authorityI an in�ation-averse monetary authority
I No commitment to future policiesI Quantitative exercise:
I Vary the degree of monetary conservatism
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Preview of results
I Increasing the degree of monetary conservatism leads toI less in�ation, higher average debt and more defaults,I more volatile public spending but more stable in�ation,I sign and size of welfare gains depends on details of theeconomy.
I Monetary conservatism is successful in reducing in�ation andcan be desirable despite considerable negative side e¤ects.
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Related literature
I Time-consistent monetary policy and central bankindependence:
I Rogo¤ (1985), Adam and Billi (2008), Niemann (2011),Martin (2015)
I Monetary policy and sovereign default:I Aguiar et al. (2013, 2015), Hur et al. (2014), Du and Schreger(2015), Nuño and Thomas (2015), Röttger (2015)
I Quantitative sovereign default models with incompletemarkets:
I Aguiar and Gopinath (2006), Arellano (2008), Cuadra andSapriza (2008)
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Overview
1. Introduction
2. Model3. Quantitative Analysis
4. Summary
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Setting
Arellano-Eaton-Gersovitz-type small open economy model:
I HouseholdsI Government
) Two separate authorities that optimize without commitment:
1. Fiscal authority
- chooses �scal policy- is subject to political economy comstraints.
2. Monetary authority
- controls the in�ation rate- might be in�ation averse
I Risk-neutral foreign investors
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Households
I The economy is populated by a representative household withpreferences
U = E0
" 1Xt=0
�tU (gt ; �t)
#; 0 < � < 1;
withU (gt ; �t) = u (gt)� (�t) :
I Interpretation of (convex) in�ation cost function (�t):I Direct utility loss of in�ation (Aguiar et al., 2013, 2015).I Resource losses of in�ation and household utility that is linearin private consumption.
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Fiscal authority
I Inspired by Cuadra and Sapriza (2008) and Aguiar andAmador (2011), there are two political parties i 2 I �f1; 2gwith preferences
Fi = E0
" 1Xt=0
�tUFi (gt ; �t)
#;
whereUFi (gt ; �t) = ~�itu (gt)� (�t) ;
with~�it =
�� > 1; if i is in o¢ ce1; if i is not in o¢ ce
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Fiscal authority (cont�d)
I Given random tax revenue � t , the incumbent party chooses�scal policy without commitment:
I default dt 2 f0; 1g, public good gt , debt issuance bt+1.I Incumbent party remains in o¢ ce with probability � and isreplaced with probability 1� �.
I Political disagreement (� > 1) and turnover risk (� < 1):
) De�cit bias (Persson and Svensson, 1989, Alesina andTabellini, 1990) and suboptimal policies relative to � = 1 (and� = 1).
I Closely related to the present bias in models withquasi-geometric discounting (see e.g. Aguiar and Amador,2011).
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Monetary authority
I The monetary authority (or central bank) has preferences
M = E0
" 1Xt=0
�tUM (gt ; �t)
#;
whereUM (gt ; �t) = u (gt)� � (�t) ;
with � � 0.I central bank sets the in�ation rate �t without commitment.I Parameter � re�ects degree of monetary conservatism(Rogo¤, 1985, Niemann, 2011)
I For � 6= 1 (� 6= �� � 1=�), the relative weight on the in�ationcost deviates from that for the households (�scal authority).
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Government budget constraintRepayment case
I Fixed debt structure (see Chatterjee and Eyigungor, 2012):I Constant nominal debt share �:
bNt+1 =BNt+1Pt
= �bt+1;
bRt+1 = (1� �)bt+1;
withbt+1 = bNt+1 + bRt+1:
I Government budget if debt is honored:
� t + (�qNt + (1� �) qRt) bt+1 = gt +����1t + 1� �
�bt ;
with random tax revenues � t .
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Government budget constraintDefault case
I Following Arellano (2008), there are two types of defaultcosts:
I Resource losses �(� t) � 0.I Temporary exclusion from �nancial markets.
I Government budget in default case:
� t � �(� t) = gt :
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International investors
I Homogeneous risk-neutral foreign investors can borrow at therisk-free rate rf and maximize expected pro�ts.
I The price of a real bond is given as
qR (bt+1; � t) =1
1+ rfEt [1�D(bt+1; � t+1)] ;
while a nominal bond is priced according to
qN (bt+1; � t) =1
1+ rfEt�1�D(bt+1; � t+1)�r (bt+1; � t+1)
�;
where D(�) and �(�) determine the default and in�ationdecisions dt+1 and �t+1.
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Policy interaction
I Interaction between periods:I Markov-perfect policy game with state (b; �)I Authorities take as given future policies but can a¤ect themvia b0.
I Interaction within periods:I Timing after tax revenues � are realized:
1. Fiscal authority chooses d 2 f0; 1g.2. Central bank chooses �.3. Fiscal authority chooses g and b0.
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Public policy problemsStep 1: Fiscal policy problem
I After tax revenues � are realized, the �scal authority solves
F(b; �) = maxd2f0;1g
n(1� d)F r (b; �) + dFd (�)
oI The beginning-of-period values of the central bank and theparty not in o¢ ce satisfy
M(b; �) = (1�D(b; �))Mr (b; �) +D(b; �)Md (�);
F�(b; �) = (1�D(b; �))F�r (b; �) +D(b; �)F�d (�);
with D(�) denoting the policy function for the �scalauthority�s default decision.
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Public policy problemsStep 2: Monetary policy problem
The central bank solves
Mr (b; �) = max�
(u(Gr (�; b; �))� � (�)
+�E� 0j�hM(Br (�; b; �); � 0)
i ) ;if the �scal authority repays and
Md (�) = max�
8<: u(Gd (�; �))� � (�)
+�E� 0j��
�M(0; � 0)+ (1� �)Md (� 0)
� 9=; ;
if it defaults.
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Public policy problemsStep 3: Fiscal policy problem
In the repayment case, the �scal authority solves
F r (�; b; �) = maxg ;b0
8<:�u(g)� (�)
+�E� 0j��
�F(b0; � 0)+ (1� �)F�(b0; � 0)
� 9=;subject to 0 � � � g �
����1 + 1� �
�b
+��qN
�b0; �
�+ (1� �)qR
�b0; �
��b0
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Public policy problemsStep 3: Fiscal policy problem (cont�d)
In the default case, the �scal authority solves
Fd (�; �) = maxg
8>>>><>>>>:�u(g)� (�)
+��E� 0j��
�F(0; � 0)+ (1� �)F�(0; � 0)
�+(1� �)�E� 0j�
��Fd (� 0)
+ (1� �)F�d (� 0)
�9>>>>=>>>>;
subject to 0 � � � g � �(�)
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Public policy problemsStep 3: Political party not in o¢ ce
The value functions for the party not in o¢ ce satisfy
F�r (�; b; �) =
8<:u(Gr (�; b; �))� (�)
+�E� 0j��
�F(Br (�; b; �); � 0)+ (1� �)F�(Br (�; b; �); � 0)
� 9=; ;
F�d (�; �) =
8>>>><>>>>:u(Gd (�; b; �))� (�)
+��E� 0j��
�F(0; � 0)+ (1� �)F�(0; � 0)
�+(1� �)�E� 0j�
��Fd (� 0)
+ (1� �)F�d (� 0)
�9>>>>=>>>>; :
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Public policy problemsStep 3: Monetary authority
The value functions for the central bank satisfy
Mr (�; b; �) =
(u(Gr (�; b; �))� � (�)
+�E� 0j�hM(Br (�; b; �); � 0)
i ) ;Md (�; �) =
8<:u(Gd (�; b; �))� � (�)+��E� 0j� [M(0; � 0)]
+ (1� �)�E� 0j��Md (� 0)
�9=; :
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Equilibrium policies
In equilibrium, all values and policies will only be functions of thebeginning-of-period state variables:
X r (b; �) = X r (�r (b; �); b; �);X d (�) = X d (�d (�); �);
for X 2fB;F ;F�;Gg, and
X (b; �) = (1�D(b; �))X r (b; �) +D(b; �)X d (�);
for X 2fB;F ;F�;G;M;�g.
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Overview
1. Introduction
2. Model
3. Quantitative Analysis4. Summary
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Functional forms
I CRRA utility:
u(g) =
(g 1�
1� if 6= 1ln g if = 1
I Quadratic in�ation costs as in Calvo and Guidotti (1992):
(�) =�
2(� � 1)2 ; � > 0;
I Asymmetric default costs as in Arellano (2008):
�(�) = max f0; � � ��g ;
I Tax revenues follow a log-normal AR(1)-process:
� t = ��t�1 exp (�"t) ; "ti :i :d :� N(0; 1); 0 < � < 1:
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CalibrationModel calibration (no CBI, one model period is one quarter):
Parameter Description Value Target
rf Risk-free rate 0.017 Arellano (2008)
� Discount factor 1/(1+rf ) - CRRA 2 Standard value
� Probability of reentry 0.1 Aguiar/Gopinath (2006)
� Share of nominal debt 0.58 Du/Schreger (2015)
� Probability of reelection 0.9 Cuadra/Sapriza (2008)
� Persistence revenue process 0.9 Standard value
� Std. dev. revenue process 0.022 Std. of g in Mexico� Probability of reelection 0.9 Cuadra/Sapriza (2008)
�� Default cost parameter 0.982 1% default prob.
� Weight on public good 2.75 20.68% avg. in�ation
� In�ation cost parameter 1.53 Mean(b=� ) = 0.05
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Bond price schedules and policy functions at � = E [� ]
0 0.05 0.10.7
0.8
0.9
1q N
b'0 0.05 0.1
0.75
0.8
0.85
0.9
0.95
1
b'
q R
0 0.05 0.10
0.02
0.04
0.06
0.08
0.1
b
π 1
0 0.05 0.10.03
0.04
0.05
0.06
0.07
0.08
b
b' α=αθ
α=2αθ
α=10αθ
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Simulation results
I Quantitative model analysis compares model statisics fordi¤erent monetary policy regimes
I Values for � relative to �� � 1=�
No CBI � = �� � = 2�� � = 10��Avg. default prob. (annual) 0.0087 0.0085 0.0155 0.0192Mean(b=� ) 0.0531 0.0519 0.0654 0.0708Mean(� � 1) (annual) 0.2095 0.2116 0.1322 0.0291Std(g )/Std(� ) 1.1041 1.0957 1.1956 1.2614Std(�)/Std(� ) 1.3399 1.3118 1.2152 0.3263Welfare measure ! (in %) - 0.0005 0.0523 0.1051
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Role of political frictions
I Consider model versions with � < 1=(1+ r f ):I No political frictions: � = 1, � = 1I No turnover risk: � > 1, � = 1
I Parameters �� , � and � re-calibrated to match long-run targets
� = �� � = 2�� � = 3�� � = 10��� = 1, � = 1 0 -0.0227 -0.0244 -0.0272� > 1, � = 1 0 0.0458 0.0729 0.0973� > 1, � < 1 0.0005 0.0523 0.0789 0.1051
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Overview
1. Introduction
2. Model
3. Quantitative Analysis
4. Summary
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Summary
I The role of monetary conservatism has been revisited in aquantitative sovereign default model with
I incomplete �nancial markets,I lack of commitment to debt repayment,I political economy distortions.
I Increasing a central bank�s degree of monetary conservatismleads to
I higher average debt, more defaults and less in�ation,I more volatile public spending but more stable in�ation,I welfare gains or costs depending on political frictions.
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References
Adam, K. and R. Billi (2008): "Monetary Conservatism and Fiscal
Policy," Journal of Monetary Economics, 55(8), 1376-1388.
Aguair, M. and M. Amador (2011): "Growth in the Shadow of
Expropriation," Quarterly Journal Of Economics, 126(2), 651-697.
Aguiar, M., M. Amador, E. Farhi, and G. Gopinath (2013): "Crisis and
Commitment: In�ation Credibility and the Vulnerability to Sovereign Debt
Crises," mimeo.
Aguiar, M., M. Amador, E. Farhi, and G. Gopinath (2015): "Coordination
and Crisis in Monetary Unions," Quarterly Journal of Economics, 130(4),
1727-1779.
Alesina, A. and G. Tabellini (1990): "A Positive Theory of Fiscal De�cits
and Government Debt," Review of Economic Studies, 57(3), 403-414.
Arellano, C. (2008): "Default Risk and Income Fluctuations in Emerging
Economies," American Economic Review, 98(3), 690-712.
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References (cont�d)
Calvo, G.A. and P.E. Guidotti (1992): "Optimal Maturity of Nominal
Government Debt: An In nite-Horizon Model," International Economic
Review, 33(4), 895-919.
Carstens, A. and L.I. Jácome (2005): "Latin American Central Bank
Reform: Progress and Challenges," IMF Working Papers 05/114.
Chatterjee, S. and B. Eyigungor (2012): "Maturity, Indebtedness, and
Default Risk," American Economic Review, 102(6), 2674-2699.
Cuadra, G. and H. Sapriza (2008): "Sovereign Default, Interest Rates and
Political Uncertainty in Emerging Markets," Journal of International
Economics, 76(1), 788-811.
Du, W. and J. Schreger (2015): "Sovereign Risk, Currency Risk, and
Corporate Balance Sheets," mimeo.
Hur, S., I. Kondo, and F. Perri (2014): "Infation, Debt, and Default,"
mimeo.
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References (cont�d)
Martin, F.M. (2015): "Debt, In�ation and Central Bank Independence,"
European Economic Review, 79, 129-150.
Niemann, S. (2011): "Dynamic Monetary-Fiscal Interactions and the Role
of Monetary Conservatism," Journal of Monetary Economics, 58(3),
234-247.
Nuño, S. and C. Thomas (2015): "Monetary Policy and Sovereign Debt
Vulnerability," mimeo.
Persson, T. and L.E.O. Svensson (1989): "Why a Stubborn Conservative
Would Run a De�cit: Policy with Time-Inconsistent Preferences,"
Quarterly Journal of Economics, 104(2), 325-345.
Röttger, J. (2015): "Monetary and Fiscal Policy with Sovereign Default,"
mimeo.
Rogo¤, K. (1985): "The Optimal Degree of Commitment to an
Intermediate Monetary Target," Quarterly Journal of Economics, 100(4),
1169-89.36 / 36