The Role of Dispersed Information in Maintaining Low Interest Rates

When public debt is issued in domestic currency, any sudden confidence crisis in the repayment ability of the government need not trigger a default, since it can be accommodated by temporary monetary financing, converting default risk into inflation risk. When the default risk premium is determined by well-informed financial intermediaries while inflation arises from the choices of less-informed workers and producers, this conversion masks adverse news, at least temporarily, and results in lower interest rates following adverse shocks. In this paper, we assess the importance of this channel, and the extent to which it is eroded when persistent fiscal shortfalls shift the prior held by all agents in the economy about the eventual resolution of the imbalance.