Monetary Policy under Fiscal Risk

Abstract

Fiscal stance and sovereign credibility shape monetary policy transmission even outside fiscal dominance. Using a panel of advanced and emerging economies since the mid-1990s, we show that sovereign-risk regimes differ less by headline debt than by borrowing costs, debt composition, and interest burdens. Elevated sovereign risk weakens the transmission of monetary policy, foreign-exchange intervention, macroprudential tools, and capital-flow measures to prices, exchange rates, and output. A small open-economy model with a fiscal block can rationalize these patterns. Emerging markets operate under tighter fiscal constraints, rely more on multi-instrument configurations, and face a narrower stabilization frontier, including cases in which conventional tightening loses its disinflationary effect.