“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. (JEL E31, E43, E52, E62, G01, H63)