https://macropaperwarehouse.com/authors/gabriel-mihalache/Gabriel MihalacheHugo -- gohugo.ioen-ushttps://macropaperwarehouse.com/papers/monetary-policy-and-sovereign-risk-in-emerging-economies-nk-default/https://macropaperwarehouse.com/papers/monetary-policy-and-sovereign-risk-in-emerging-economies-nk-default/<p>This paper develops a New Keynesian small open economy model with endogenous sovereign default — the NK-Default framework — and uses it to study the interplay between monetary policy and sovereign risk in emerging markets. The core finding is that sovereign default risk amplifies inflation volatility through an expectations channel: when default risk rises, forward-looking firms increase prices in expectation of high future inflation and depressed consumption during a potential default, so that current inflation rises even before any default occurs. Conversely, tight monetary policy disciplines government overborrowing by raising the cost of domestic monetary distortions, which the government internalizes by reducing its borrowing. Calibrated to eight emerging-market inflation targeters (Brazil, Chile, Colombia, Mexico, Peru, Philippines, Poland, South Africa) over 2004–2019, the model quantitatively matches the positive comovement of spreads with inflation and nominal rates, and the temporary nature of inflation events (approximately 4.5% inflation spike, 2.3% spread increase, resolved within roughly a year). Counterfactual experiments find that default risk accounts for approximately 50% of both inflation business-cycle volatility and the inflation increase during these events, and that a 1% tighter monetary policy would reduce spreads by about 0.3% during inflation events. An interest rate rule augmented to respond to default risk dominates strict inflation targeting in welfare and reduces mean spreads by 2.2 percentage points; strict inflation targeting is not the optimal monetary regime when sovereign risk is present.</p>