The importance of default risk awareness in conducting monetary and fiscal policies

• Published in: Eurasian economic review Vol. 10; no. 3; pp. 361 - 392
• Main Authors: Okano, Eiji, Eguchi, Masataka
• Format: Journal Article
• Language: English
• Published: Cham Springer International Publishing 01.09.2020; Springer Nature B.V
• Subjects: Default; Economics; Economics and Finance; Equilibrium; Inflation; Monetary policy; Original Paper; Welfare; Fiscal theory of the price level; E52; Optimal monetary policy; Sovereign risk; E60
• ISSN: 1309-422X; 2147-429X
• DOI: 10.1007/s40822-020-00143-4

We developed a class of dynamic stochastic general equilibrium models with nominal rigidities to investigate the importance of default risk awareness in developing and implementing monetary and fiscal policies. We introduced default risk in the model and analyzed two policies: exact policies and false policies. The exact policy includes optimal monetary and fiscal policies as well as policy authorities who are aware of default risk. The false policy includes optimal monetary and fiscal policies as well as policy authorities who are unaware of default risk. We calculated the coefficients of simple rules that are a class of Taylor rules and a class of the Bohn rule. We found that there is no distinction on simple rules between the exact and false policies if the interest spread in the steady state is low. However, if the interest spread is high, policy authorities should not stabilize inflation and minimize the premium difference. We calculated welfare costs under the two policies. If the interest spread is low, there is a large difference in welfare costs between the two policies, and if the spread is high, the difference between the welfare costs is further increased. If policy authorities are unaware of the default risk, they introduce a stricter policy that generates significant welfare costs. If the interest spread is high, policy authorities should be aware of the default risk.