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Excess debt and monetary policy in the Slovak Republic

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We are investigating the consequences of excessive growth of international debt, as they relate to both debtor and creditor countries. In particular, we assess the impact of monetary policy on financial stability and how it can be used to smooth borrowers, as well as lenders, consumption during the business cycle. Based on [Goodhart, Peiris, Tsomocos, 2018], we establish that an independent anti-cyclical monetary policy that reduces liquidity whenever debt increases, while expanding it when default increases, reduces consumption volatility. In fact, monetary policy provides policy with an additional degree of freedom. We apply our approach to the economy of Slovakia and the Eurozone countries in the 1990 s. In our model, we introduce an endogenous default in la [Shubik, Wilson, 1977], according to which debtors incur social security costs when renegotiating their contractual debt obligations that are commensurate with the level of default. However, this cost depends directly on the business cycle and should be countercyclical. Consequently, restraining monetary policy reduces trade volume and efficiency, thereby increasing default. This occurs when the default cost increases the associated default accelerator channel, generating higher default speeds. On the other hand, lower interest rates increase trading efficiency and, consequently, reduce the amplitude of the business cycle and contribute to financial stability. In General, the appropriate monetary policy design complements the financial stability policy. Modeling endogenous default allows us to study the interaction of monetary and macroprudential policies.

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