Real Interest Rates and Government Debt during Stabilization

Andreas Velasco

Journal of Money, Credit and Banking, 1993, vol. 25, issue 2, 259-72

Abstract: High real interest rates typically accompany successful disinflations. If government deficits are financed with domestic debt, this behavior of interest rates can be destabilizing. High interest rates increase debt service costs and contribute to the accumulation of debt, threatening the whole anti-inflation effort. The exchange rate regime matters in this context. Under perfectly flexible exchange rates, the real interest rate is invariant to changes in the rate of money creation. By contrast, the real rate of interest tends to rise when an economy under predetermined exchange rates is disinflated via the type of 'exchange rate management' analyzed by Drazen and Helpman (1987). Rules for fiscal and/or monetary policies are developed to ensure that the economy reaches a new, low-inflation steady state in the aftermath of stabilization effort. Copyright 1993 by Ohio State University Press.

Date: 1993
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