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Why Prices Don't Respond Sooner to a Prospective Sovereign Debt Crisis

  • R. Anton Braun

    (Federal Reserve Bank of Atlanta (Email: r.anton. braun@gmail.com))

  • Tomoyuki Nakajima

    (Institute of Economic Research, Kyoto University, and the Canon Institute for Global Studies (Email: nakajima@kier.kyoto-u.ac.jp))

We compare the dynamics of inflation and bond yields leading up to a sovereign debt crisis in settings where asset markets are frictionless to other settings with financial frictions. As compared to the case with frictionless asset markets, an asset market structure with financial frictions generates a significant delay in the response of prices to news about a future debt crisis. With complete markets prices jump in response to news about the possibility of a future debt crisis. However, when short selling of government bonds is restricted some agents can't act on their beliefs and prices don't respond to the news. Instead prices only move in periods immediately prior the crisis.

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Paper provided by Institute for Monetary and Economic Studies, Bank of Japan in its series IMES Discussion Paper Series with number 12-E-02.

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Date of creation: Mar 2012
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Handle: RePEc:ime:imedps:12-e-02
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  1. Marco Bassetto & R. Andrew Butters, 2010. "What is the relationship between large deficits and inflation in industrialized countries?," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q III, pages 83-100.
  2. Marco Bassetto, 2002. "A Game-Theoretic View of the Fiscal Theory of the Price Level," Econometrica, Econometric Society, vol. 70(6), pages 2167-2195, November.
  3. Huixin Bi, 2010. "Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy," Caepr Working Papers 2010-007, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  4. Carmen M. Reinhart & Kenneth S. Rogoff, 2010. "From Financial Crash to Debt Crisis," NBER Working Papers 15795, National Bureau of Economic Research, Inc.
  5. Selahattin Imrohoroglu & Nao Sudo, 2010. "Productivity and Fiscal Policy in Japan: Short Term Forecasts from the Standard Growth Model," IMES Discussion Paper Series 10-E-23, Institute for Monetary and Economic Studies, Bank of Japan.
  6. Todd Walker & Eric Leeper & Troy Davig, 2010. "Inflation and the Fiscal Limit," 2010 Meeting Papers 837, Society for Economic Dynamics.
  7. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
  8. Sebastián Nieto Parra, 2008. "Who Saw Sovereign Debt Crises Coming?," OECD Development Centre Working Papers 274, OECD Publishing.
  9. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
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