Insights into the sovereign-bank nexus: Can inflation and money supply affect the doom loop?

Key findings from this study

• The study found that high debt ratios paired with accommodative monetary policy constitute the primary driver of spillovers constraining bank lending and sustaining the doom loop dynamic.
• The authors report that inflation functions as a financial stabilizer within the sovereign-bank nexus, enhancing system resilience to debt and liquidity shocks.
• The researchers demonstrate that public debt accumulation generates inflationary pressures, establishing a causal pathway from fiscal imbalance to price dynamics.

Overview

This study examines how inflation and money supply dynamics influence the relationship between sovereign debt and bank lending capacity. Using quarterly data from 1966 onward covering debt-to-GDP ratios, bank lending volumes, inflation rates, and M3 money supply, the authors apply quantile vector autoregression analysis across different market conditions. The research addresses whether expansionary monetary policy and inflationary pressures amplify or mitigate the feedback loop between rising public debt and constrained bank lending capacity.

Methods and approach

The analysis employs a Quantile-VAR framework applied to quarterly time series spanning from 1966. Variables include the debt-to-GDP ratio, bank lending capacity, inflation rates, and M3 money supply. The quantile approach permits examination of relationships across different percentiles of the conditional distribution, enabling differentiation between normal and stressed market regimes. This methodological choice allows the authors to assess whether spillover mechanisms operate uniformly or vary systematically with market conditions.

Results

High debt ratios combined with accommodative monetary policy generate the primary spillover channel constraining bank lending and perpetuating the sovereign-bank feedback cycle. Inflation, conversely, functions as a stabilizing force within this system by increasing resilience to shocks from excess debt accumulation or liquidity injections. The relationship exhibits asymmetry: debt ratios feed inflationary pressures, suggesting a directional causal pathway from fiscal imbalance to price-level dynamics. The magnitude and direction of these effects vary across quantiles, indicating regime-dependent transmission mechanisms.

Implications

The findings suggest that managing the sovereign-bank nexus requires simultaneous attention to fiscal consolidation and monetary restraint rather than treating these policy domains independently. Expansionary central bank actions amplify vulnerability to debt-related shocks when coupled with high leverage, indicating coordination failures in macroprudential policy. The stabilizing role of inflation carries important trade-offs, as relying on price-level rises to mitigate debt burdens introduces cost-push inflation risks and potential distributional consequences across creditor and debtor classes.

These results challenge the assumption that monetary accommodation uniformly supports financial stability. Rather, the interplay between debt levels and money supply creates conditional dynamics where loose policy becomes destabilizing above certain debt thresholds. Policymakers implementing macroprudential frameworks must account for these nonlinearities, particularly regarding interconnections between fiscal sustainability and banking sector health. The quantile approach reveals that policy effectiveness differs markedly between tranquil and stressed regimes.

Scope and limitations

This summary is based on the study abstract and available metadata. It does not include a full analysis of the complete paper, supplementary materials, or underlying datasets unless explicitly stated. Findings should be interpreted in the context of the original publication.