ABSTRACT

The note is the second of a series of four notes written for students on current policy debates. It focuses on a simple open economy model in which there is a subjective default probability on domestic debt. Under certain conditions there is more than one pair interest/exchange consistent with a given inflation target. Dynamics is explored under a simple behavior rule according to which Central Bank increases interest if inflation is above target. The effect of credible fiscal tightening, external shocks in interest rates or sovereign debt and expected changes in the convertibility regime are discussed.

KEYWORDS:
Interest rate; double balance; convertibility; sovereign risk