Incorporating sovereign risk into the design of the inflation targeting regime

Abstract

The paper analyzes the coordination between monetary and fiscal policy in an emerging economy with monetary regime type inflation targets, to accommodate exogenous shocks and to maintain such economy in a stable equilibrium in a situation where the risk of default contributes to the instability of the debt and the monetary policy interest rate. An analytical framework is developed to capture the mechanisms of transmission of sovereign risk and its effects on the definition of reactions functions for monetary and fiscal authority. For this, a model of simultaneous first order differential equations was used, where the steady state of the model and its stability were analyzed. The main results show that in case of fiscal rules, with the imposition of a primary surplus, the monetary authority should have a higher weight of inflation deviations from the inflation target, so that a tax control is desired for the economy is not very vulnerable to sovereign risk shocks. In a setting where there is no fiscal rule it is necessary that the monetary authority accommodates the shock of sovereign risk, through increases in the basic interest rate.