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Speaker:
Leopold Zessner-Spitzenberg (Humboldt University Berlin)

Monetary policy under sovereign risk
^{(with Martin Wolf)}

Abstract: We study monetary policy in a currency union under the risk of default of a member. Since default is inefficient from a union perspective, the monetary authority has an incentive to prevent current and future defaults. The monetary authority affects the cost of debt and thereby the incentives for borrowing and default by setting the nominal interest rate. We decompose the effect of the interest rate on borrowing into a positive income effect and a negative substitution effect. The relative strength of the two effects depends on the current level of outstanding debt. As a result, a rate increase lowers default risk below a critical threshold of debt to GDP, while it raises default risk above the threshold.

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