Conducting Monetary Policy with Large Public Debts. Gita Gopinath Harvard University

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1 Conducting Monetary Policy with Large Public Debts Gita Gopinath Harvard University 1

2 Large Public Debts Net Government debt to GDP Greece 155 Japan 134 Portugal 111 Italy 103 Ireland 102 United States 87 France 84 United Kingdom 82 Spain 71 2

3 Large Public Debts Net Government debt to GDP Greece 155 Japan 134 Portugal 111 Italy 103 Ireland 102 United States 87 France 84 United Kingdom 82 Spain 71 3

4 Self-fulfilling Crises 4

5 Self-fulfilling Crises 5

6 Questions 1. Does ability to inflate reduce exposure to rollover crises? 2. Should monetary policy play an active role in debt crises? 3. How much of inflation commitment is optimal? 6

7 Papers Aguiar, Amador, Farhi and Gopinath (2014) Crisis and Commitment: Inflation Credibility and the Vulnerability to Self-fulfilling debt crisis Coordination and Crises in a Monetary Union 7

8 Case 1: SOE Case 2: MU Monetary Policy Monetary Policy Fiscal Policy Fiscal Policy Fiscal Policy 8

9 ! Environment (SOE) Government issues nominal bonds Lenders expect real risk free rate compensated for expected inflation and default risk. 9

10 Environment 1. Preferences Z 1!! 0 e r t (u(c t ) 0 t ) dt 2. Budget Constraint c t = y + ḃt (r t t ) b t 10

11 Environment Government lacks commitment to inflation: Cost 0! 1!! High Temptation Low Temptation Foreign currency debt:!1 11

12 Environment Government lacks commitment to repay -Cost is exclusion from financial markets 12

13 Roll-over Risk Coordination failure among lenders For high values of debt if each lender thinks all other lenders will roll-over: no crises if each lender thinks all other lenders will not roll-over: then debt run 13

14 Constructing Debt Runs Suppose the government cannot roll over To avoid default, needs to repay generate fiscal surpluses use inflation If the value of repayment is below the default value roll-over crisis is self-fulfilling: vulnerable to crisis 14

15 Debt Threshold How does the vulnerability debt cut-off depend on the ability to inflate? 15

16 Debt Threshold risis Region as a function of Debt Vulnerable b Safe 0 16

17 Crisis Region as a function of Debt Debt Threshold Vulnerable b Safe 0 Two extremes cases: =0 and = 1 In the first: inflate all the time In the second: never inflate Same vulnerability: inflation is not state contingent 17

18 Crisis Region as a function of Debt Debt Threshold Vulnerable b Safe 0 More generally two opposite effects when increases Increases the cost of repaying in case of a run It may reduce equilibrium inflation Reduces equilibrium interest rate Reduces the cost of repaying in case of a run / 35

19 Crisis Region as a function of Debt Debt Threshold Vulnerable b Safe 0 More generally two opposite effects when increases Increases the cost of repaying in case of a run It may reduce equilibrium inflation Reduces equilibrium interest rate Reduces the cost of repaying in case of a run / 35

20 Crisis Region as a function of Debt Debt Threshold Vulnerable b Safe 0 More generally two opposite effects when increases Increases the cost of repaying in case of a run It may reduce equilibrium inflation Reduces equilibrium interest rate Reduces the cost of repaying in case of a run 33 / 35 20

21 Monetary Union 1. Fiscal Externality 2. Heterogenous Debt Levels 21

22 Heterogeneity in Public Debts in Euro Area Net Government debt to GDP Greece 155 Portugal 111 Italy 103 Ireland 102 France 84 Spain 71 Germany 57 Netherlands 32 22

23 Fiscal Externality Countries do not internalize the impact of their debt decisions on borrowing costs Too much debt Not save enough Too high inflation

24 Heterogenous Debt Levels Incentive to inflate depends on the fraction of high debtors in the union. Roll-over risk makes joining a union with low debtors costly for high debt countries. Monetary intervention off-equilibrium promise, so lowdebtors do not have to necessarily loose.

25 Take Aways Does ability to inflate reduce exposure to rollover crises? Not necessarily Should monetary policy play an active role in debt crises? Yes How much of inflation commitment is optimal? Intermediate 25

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