Inflation, Debt, and Default

Illenin Kondo, Fabrizio Perri and Sewon Hur

No 1610, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: We show that the co-movement of inflation and domestic consumption growth affects both the pricing and the dynamics of nominal domestic debt. In particular a positive co-movement of inflation and consumption makes returns on government bonds negatively correlated with domestic consumption: this lowers risk premia on nominal domestic debt as seen in the data. However, as this co-movement increases, the debt becomes more risky for the government and reduces its incentives to accumulate debt. We find that debt accumulation is overall stronger the higher the co-movement of inflation and consumption. To assess these joint equilibrium properties of debt and interest rates, we calibrate a simple model of domestic default and nominal debt in the presence of exogenous inflation risk and domestic risk averse agents. Consistent with the data, the model also reveals that increased co-movement of inflation and consumption leads to more volatile interest rates.

Date: 2016
New Economics Papers: this item is included in nep-dge and nep-mac
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Citations: View citations in EconPapers (8)

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Working Paper: Inflation, Debt, and Default (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed016:1610

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