Overview
Speaker: Ozge Akinci
This discussion reviews a paper proposing an open-economy New Keynesian DSGE model with two frictions—sticky prices and sovereign default risk—to study how fiscal policy interacts with monetary policy when default risk is present. The core result: expectations of default act like a cost-push shock in the New Keynesian framework, making inflation stabilization harder and generating co-movements observed in data: high inflation, high sovereign spreads, high nominal interest rates, and low output.
Model and Mechanism: “Default Amplification”
- Adverse productivity shock triggers an output collapse. In a small open economy, agents borrow internationally to smooth consumption, raising external debt.
- Higher external debt increases the likelihood of default. Because default states feature low consumption and high inflation, firms expect higher future inflation and higher marginal utility of consumption.
- Via the New Keynesian Phillips curve, higher expected future inflation (and higher marginal utility) raises current pricing, lifting current inflation even without directly linking inflation to productivity.
- Under a standard Taylor rule, the central bank increases the nominal interest rate, which reduces current domestic consumption (via the Euler equation), amplifying the downturn.
- Outcome: the mechanism aligns with observed episodes of high inflation, high spreads, high nominal rates, and low output.
Scope of Shocks and Key Questions Raised
- Beyond supply/productivity shocks: Does the mechanism extend to any shock that raises default likelihood (e.g., demand shocks)?
- Global financial cycle: Can the New Keynesian default framework reconcile empirical spillovers from US monetary policy to emerging markets (EM), notably the inflation response?
- Exchange rate role: In EM contexts, how do exchange rate movements contribute to the mechanism and observed outcomes?
Global Financial Cycle Evidence and Interpretation
- Empirical results (quarterly data for 25 EM from 1965; local projections on identified US monetary policy shocks):
- An unexpected 100 basis point increase in the federal funds rate reduces US GDP by 0.8%.
- EM GDP falls by more than the US; EM headline inflation rises significantly, and short-term PPI (domestic prices) also increases.
- EM central banks raise policy rates (Taylor rule) despite the output drop.
- State dependence: When EM inflation is elevated, PPI and nominal interest rates increase markedly despite a large output decline.
- Limitation of the New Keynesian Reference Model (Gali-Monecelli): It delivers spread and output spillovers but implies falling producer price inflation and lower nominal interest rates—at odds with EM inflation dynamics.
- Alternative (discussant’s prior work with Albert Geraldo): Unanchored inflation expectations (partly adaptive) can explain co-movement of high inflation and low output after large depreciations; the default-risk mechanism may be complementary.
Authors’ Responses
- Generalization across shocks: The mechanism persists for any shock that raises future default risk; through the New Keynesian Phillips curve, higher default risk increases expected future inflation or raises future marginal utility, acting like a cost-push shock that lifts current inflation.
- US monetary policy shock: Not studied in the paper; in the model, tighter US policy raises international borrowing costs and default risk, triggering the same amplification. The net effect among channels merits future study.
- Exchange rate: With flexible exchange rates (as in EM inflation targeting), model-implied exchange rate movements are consistent with data, though not very volatile.
Audience Q&A Highlights
- EM specificity: The framework applies to any country with default risk and inflation targeting; the author cautioned it may not yet be a good model for France because of the monitoring unit.
- Global factor in risk pricing: For EM, about 80% of the variation in the CBS price is attributed to a global factor, underscoring the importance of global shocks (including US monetary policy and related shocks). Authors agree risk-per-membership would be another useful shock to assess.
- Debt maturity: The paper uses long-term debt following the literature; in a simple example, short-term debt also works.
Next Steps / Actions
- Extend the framework to a two-country setting to analyze US monetary policy spillovers, tracking how default likelihood transmits and affects EM inflation and output.
- Quantify the relative strength of default-amplification versus demand channels under US monetary tightening.
- Evaluate additional shocks (e.g., risk-per-membership) and assess model fit against global factor-driven movements in EM spreads.
- Further examine the role and volatility of exchange rate dynamics under flexible regimes within the model.