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Default Risk on Government Bonds, Deflation, and Inflation

  • Oguro, Kazumasa
  • Sato, Motohiro

This paper analyzes the impact of deflation and inflation on the real interest rates of GBs using an overlapping generations model with the relationship between the real interest rate of GBs and the fiscal consolidation rule. We find that deflation may lower the real interest rate of GBs to the same level of public debt to capital, even if the fiscal consolidation rule is the same, as opposed to the conventional view that the real interest rate of GBs is determined independent of deflation if the Fisher equation holds. Our results are consistent with how the real interest rates of Japanese GBs react in periods of deflation. This paper also addresses the impact of fiscal inflation (i.e., monetizing all parts of the GB’s default using monetary policy). We calculate the expected fiscal inflation when the default rate in the event of fiscal consolidation is raised. The fiscal inflation may be extremely high if the extent of the required tax increase in fiscal consolidation is low. Initial inflation accelerates the expected fiscal inflation, but initial deflation suppresses it.

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File URL: http://hermes-ir.lib.hit-u.ac.jp/rs/bitstream/10086/22186/1/cis_dp537.pdf
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Paper provided by Center for Intergenerational Studies, Institute of Economic Research, Hitotsubashi University in its series CIS Discussion paper series with number 537.

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Length: 27 p.
Date of creation: Feb 2012
Date of revision:
Handle: RePEc:hit:cisdps:537
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  1. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  2. Bernardin Akitoby & Thomas Stratmann, 2006. "Fiscal Policy and Financial Markets," IMF Working Papers 06/16, International Monetary Fund.
  3. Kazumasa Oguro & Motohiro Sato, 2014. "Public debt accumulation and fiscal consolidation," Applied Economics, Taylor & Francis Journals, vol. 46(7), pages 663-673, March.
  4. Romer, Paul M, 1986. "Increasing Returns and Long-run Growth," Journal of Political Economy, University of Chicago Press, vol. 94(5), pages 1002-37, October.
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  10. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 4(3), pages 345-80.
  11. Harald Uhlig, 2009. "A Model of a Systemic Bank Run," NBER Working Papers 15072, National Bureau of Economic Research, Inc.
  12. Bernoth, Kerstin & Schuknecht, Ludger & von Hagen, Jürgen, 2004. "Sovereign Risk Premia in the European Bond Market," CEPR Discussion Papers 4465, C.E.P.R. Discussion Papers.
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