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Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds

Author

Listed:
  • Matías Moretti
  • Lorenzo Pandolfi
  • Mr. Germán Villegas-Bauer
  • Mr. Sergio L. Schmukler
  • Tomás Williams

Abstract

We present evidence of inelastic demand for risky sovereign bonds and explore its implications for optimal government debt policies. Using monthly changes in the composition of a major international bond index, we identify flow shocks unrelated to fundamentals that shift the available bond supply. From these shocks, we estimate an inverse demand elasticity of -0.30 and show that it increases with countries’ default risk. We formulate a sovereign debt model with endogenous default and inelastic investors, calibrated to our empirical estimates. By penalizing additional borrowing, an inelastic demand acts as a disciplining device that reduces default risk and bond spreads.

Suggested Citation

  • Matías Moretti & Lorenzo Pandolfi & Mr. Germán Villegas-Bauer & Mr. Sergio L. Schmukler & Tomás Williams, 2024. "Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds," IMF Working Papers 2024/227, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:2024/227
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    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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