European Central Bank

When inflationary pressures started intensifying in 2022, the world’s major central banks faced a dilemma. They could rapidly tighten monetary policy at the risk of fuelling financial distress after years of ultra-low interest rates and balance sheet expansion. Or they could take a more gradual approach to fighting inflation that would protect the financial system, but risk high inflation becoming entrenched. While severe financial instability may be an unlikely event (or “tail risk”), it can have devastating macroeconomic consequences.

Using microdata from a U.S. household survey, we document that immigrants who lived through a sovereign default episode are 6% less likely to hold debt relative to otherwise similar immigrants who reside in the same U.S. state and come from the same foreign country but who did not experience a default. Conditional on holding debt, consumers in the former group borrow less and service lower debt burdens. The negative effect on borrowing behavior of having experienced a sovereign default increases with family size and declines with education.

We study how shocks to corporate leverage alter the macroeconomic transmission of monetary policy. We identify leverage shocks as idiosyncratic firm-level disturbances that are aggregated up to a size-weighted country-level average to generate a Granular Instrumental Variable (Gabaix and Koijen, forthcoming). Interacting this instrumental variable with high-frequency identified monetary policy shocks, we find that transmission to the price level strengthens in the presence of leverage shocks, while the real effects of monetary policy are unaffected.

What are the macroeconomic consequences of a government that is limited in its willingness or ability to raise primary surpluses, and a central bank that accommodates its interest-rate policy to the fiscal conditions? I address this question in a dynamic stochastic sticky-price model with endogenous shifts between an “orthodox” and a “fiscally-dominant” policy regime. The risk of future regime shifts has encompassing effects on equilibrium.