Monetary and Fiscal Policy with Sovereign Default

How does the option to default on debt payments affect the conduct of public policy? To answer this question, this paper studies optimal monetary and fiscal policy without commitment in a model with nominal debt and endogenous sovereign default. When the government can default on its debt, public policy changes in the short and the long run relative to a setting without default option. The risk of default increases the volatility of interest rates, impeding the government's ability to smooth tax distortions across states. It also limits public debt accumulation and reduces the government's incentive to implement high inflation in the long run. The welfare costs associated with the short-run effects of sovereign default are found to be outweighed by the welfare gains due to lower average debt and inflation.