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Published online by Cambridge University Press: 01 March 2018
By developing a class of dynamic stochastic general equilibrium models with nominal rigidities and assuming a two-country currency union with sovereign risk, we show that there is not necessarily a trade-off between the prevention of default risk and stabilizing inflation. Under optimal monetary and fiscal policy, comprising a de facto inflation stabilization policy, the tax rate as an optimal fiscal policy tool plays an important role in stabilizing inflation, although not completely because of the distorted steady state. Changes in the tax rate to minimize welfare costs via stabilizing inflation then improve the fiscal surplus, and because of this and the incompletely stabilized inflation, the default rate does not increase as much.
The authors would like to thank Alexandre Caboussat, John Barrdear, John Drifill, Masataka Eguchi, Kazuyuki Inagaki, Takashi Kano, Shigeto Kitano, Keiichiro Kobayashi, Chikafumi Nakamura, Tomomi Miyazaki, Eiji Ogawa, Shin-ichi Nishiyama, Etsuro Shioji, Akira Yakita, Naoyuki Yoshino, conference and seminar participants at Cardiff University, Chukyo University, the ESSCA Business School, the Imperial Queen's Park Hotel (Bangkok), Kyushu University, Nagoya City University, Mandarin Orchard (Singapore), Meisei University, Niigata University, Otaru University of Commerce, Queensland University of Technology, Silken Diagonal Barcelona, Yamaguchi University, Sophia University, and two anonymous referees for their helpful comments. Any errors are our own. This work was supported by JSPS KAKENHI Grant Number 25380400.
