Crisis and Commitment: Inflation Credibility and the Vulnerability to Sovereign Debt Crises
We propose a continuous time model of nominal debt and investigate the role of inflation credibility in the potential for self-fulfilling debt crises. Inflation is costly, but reduces the real value of outstanding debt without the full punishment of default. With high inflation credibility, which can be interpreted as joining a monetary union or issuing foreign currency debt, debt is effectively real. By contrast, with low inflation credibility, sovereign debt is nominal and in a debt crisis a government may opt to inflate away a fraction of the debt burden rather than explicitly default. This flexibility potentially reduces the country's exposure to self-fulfilling crises. On the other hand, the government lacks credibility not to inflate in the absence of crisis. This latter channel raises the cost of debt in tranquil periods and makes default more attractive in the event of a crisis, increasing the country's vulnerability. We characterize the interaction of these two forces. We show that there is an intermediate inflation credibility that minimizes the country's exposure to rollover risk. Low inflation credibility brings the worst of both worlds--high inflation in tranquil periods and increased vulnerability to a crisis.
|Date of creation:||Oct 2013|
|Note:||EFG IFM ME|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Du, Wenxin & Schreger, Jesse, 2013.
"Local Currency Sovereign Risk,"
International Finance Discussion Papers
1094, Board of Governors of the Federal Reserve System (U.S.).
- Carmen M. Reinhart & Kenneth S. Rogoff, 2009.
"This Time Is Different: Eight Centuries of Financial Folly,"
Princeton University Press,
edition 1, number 8973.
- Harold L. Cole & Timothy J. Kehoe, 1998.
"Self-fulfilling debt crises,"
211, Federal Reserve Bank of Minneapolis.
- José-María Da-Rocha & Eduardo-Luis Giménez & Francisco-Xavier Lores, 2013. "Self-fulfilling crises with default and devaluation," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 53(3), pages 499-535, August.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:19516. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.