The Inflation Risk Premium on Government Debt in an Overlapping Generations Model

Michael Hatcher

No 2013-81, SIRE Discussion Papers from Scottish Institute for Research in Economics (SIRE)

Abstract: This paper presents a general equilibrium model in which nominal government debt pays an inflation risk premium. The model predicts that the inflation risk premium will be higher in economies which are exposed to unanticipated inflation through nominal asset holdings. In particular, the inflation risk premium is higher when government debt is primarily nominal, steady-state inflation is low, and when cash and nominal debt account for a large fraction of consumers' retirement portfolios. These channels do not appear to have been highlighted in previous models or tested empirically. Numerical results suggest that the inflation risk premium is comparable in magnitude to standard representative agent models. These findings have implications for management of government debt, since the inflation risk premium makes it more costly for governments to borrow using nominal rather than indexed debt. Simulations of an extended model with Epstein-Zin preferences suggest that increasing the share of indexed debt would enable governments to permanently lower taxes by an amount that is quantitatively non-trivial.

Keywords: government debt; inflation risk premium; overlapping generations (search for similar items in EconPapers)
Date: 2013
New Economics Papers: this item is included in nep-dge and nep-mac
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Working Paper: The inflation risk premium on government debt in an overlapping generations model (2013)
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