Monetary and Fiscal Policy and Debt Structure in small open economies

In the past two decades, emerging economies have registered a reduction in the share of sovereign debt denominated in foreign currency and an extension in its maturity. First, I study how these changes affect the optimal monetary and fiscal policy. I derive analytical results using a commitment framework. A higher share of debt denominated in local currency increases the reliance on variations in inflation to hedge against fiscal stress, which in turn increases with the maturity. Additionally, it reduces the relative exposure to foreign shocks. Second, I study the differences in currency composition across countries, focusing on Latin America. In this case I use a time-consistency framework, to capture the large shares of debt denominated in foreign currency observed in the data. I find that large external debt-to-GDP ratios, long debt duration, and low inflation costs encourage more borrowing in inflation-indexed bonds and can explain the larger share of inflation-indexed debt in Uruguay compared to other Latin American countries.