Abstract This article develops a New Keynesian model with sovereign default risk. Inflation is set by forward-looking firms, monetary policy is an interest rate rule, and the fiscal government borrows externally, long-term, with an option to default. In this framework, default risk creates inflation pressures through an expectations channel, and tight monetary policy disincentivizes fiscal overborrowing. The model sheds light on temporary inflation events in emerging-market data: short-lived spikes in inflation, spreads, and domestic policy rates. As spreads rise, firms increase their prices in expectation of higher future inflation and low consumption during default. Monetary policy tightens, which reduces inflation and helps bring spreads down by disciplining government borrowing. These monetary-fiscal interactions imply that delivering the flexible-prices allocation may not be optimal for monetary policy.
In many economic decisions, people estimate probabilities, such as the likelihood that a risk materializes or that a job applicant will be a productive employee, by retrieving experiences from memory. We model this process based on two established regularities of selective recall: similarity and interference. We show that the similarity structure of a hypothesis and the way it is described (not just its objective probability) shape the recall of experiences and thus probability assessments. The model accounts for and reconciles a variety of empirical findings, such as overestimation of unlikely events when these are cued versus neglect of noncued ones, the availability heuristic, the representativeness heuristic, conjunction and disjunction fallacies, and over- versus underreaction to information in different situations. The model yields several new predictions, for which we find strong experimental support.