Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds

Matias Moretti (), Lorenzo Pandolfi, Sergio Schmukler, Germán Villegas Bauer () and Tomas Williams
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Matias Moretti: University of Rochester
Germán Villegas Bauer: International Monetary Fund

CSEF Working Papers from Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy

Abstract: We study how investor demand influences government borrowing capacity, default risk, and bond prices. We develop a sovereign debt model with a rich demand structure, featuring investors with asset-allocation mandates. In our framework, bond prices depend not only on government policies and default risk, but also on investor composition and demand elasticity. We estimate this elasticity from bond price responses to the periodic rebalancing of a major emerging markets bond index, which shifts investors’ allocations. We calibrate the model using this estimate and show that a downward-sloping demand acts as a disciplining device that mitigates debt dilution by curbing future issuance. This market-based mechanism lowers default risk and allows the government to sustain higher debt. Unlike standard models, where discipline arises from default penalties, our mechanism operates through investor behavior. This distinction matters for policy: with market discipline in place, fiscal rules have milder effects on borrowing and default risk.

Keywords: Sovereign Debt; Inelastic Investors; Disciplining Device; Debt Dilution; Fiscal Rules. (search for similar items in EconPapers)
JEL-codes: F34 F41 G15 (search for similar items in EconPapers)
Date: 2024-03-26, Revised 2025-10-13
New Economics Papers: this item is included in nep-dge, nep-fmk, nep-ifn and nep-opm
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Related works:
Working Paper: Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds (2025)
Working Paper: Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds (2024)
Working Paper: Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds (2024)
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