Abstract

Public debt has surged in recent years, raising concerns about fiscal sustainability and the risk of sovereign default. This paper’s key contribution is to examine optimal monetary policy under those conditions. I develop a New Keynesian model with strategic sovereign default, leveraging a novel solution method. Under standard rule‐based monetary policy, inflation rises when default risk increases. A hawkish central bank keeps inflation at target. Under discretion, a positive inflation bias emerges because the central bank has an incentive to ”run the economy hot” to erode government debt, failing to account for the inflationary pressure. However, under commitment, the inflation bias is mitigated, enabling the sovereign to borrow more.