'Whatever it takes' is all you need : monetary policy and debt fragility

Abstract

The valuation of government debt is subject to strategic uncertainty. Pessimistic lenders, fearing default, bid down the price of debt, leaving a government with a higher debt burden. This increases the likelihood of default, thus confirming the pessimism of lenders. Can monetary interventions mitigate debt fragility? With one-period commitment to a state-contingent policy, the monetary authority can indeed overcome strategic uncertainty. Under discretion, debt-fragility remains unless reputation effects are sufficiently strong. Simpler forms of interventions, such as an inflation target, cannot eliminate debt fragility.