Gambling to Preserve Price (and Fiscal) Stability

We study a model in which policy aims at aggregate price stability. A fiscal imbalance materializes that, if uncorrected, must cause inflation, but the imbalance may get corrected in the future with some probability. By maintaining price stability in the near term, monetary policy can buy time for a correction to take place. The policy gamble may succeed, preserving price and fiscal stability, or fail, leading to a delayed, possibly large jump in the price level. The resulting dynamics resemble the models of a currency crisis following Krugman (J Money Credit Bank 11:311-325, 1979) and Obstfeld (Am Econ Rev 76: 72-81, 1986). Like in Obstfeld's work, multiple equilibria arise naturally: whether or not price stability is preserved may depend on private agents' expectations. The model can be reinterpreted as a model of partial default on public debt, in which case it is reminiscent of Calvo (Am Econ Rev 78:647-661, 1988).