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Inflation, Debt, and Default

Author

Listed:
  • Illenin Kondo

    (Federal Reserve Board)

  • Fabrizio Perri

    (Federal Reserve Bank of Minneapolis)

  • Sewon Hur

    (University of Pittsburgh)

Abstract

We show that the co-movement of inflation and domestic consumption growth affects both the pricing and the dynamics of nominal domestic debt. In particular a positive co-movement of inflation and consumption makes returns on government bonds negatively correlated with domestic consumption: this lowers risk premia on nominal domestic debt as seen in the data. However, as this co-movement increases, the debt becomes more risky for the government and reduces its incentives to accumulate debt. We find that debt accumulation is overall stronger the higher the co-movement of inflation and consumption. To assess these joint equilibrium properties of debt and interest rates, we calibrate a simple model of domestic default and nominal debt in the presence of exogenous inflation risk and domestic risk averse agents. Consistent with the data, the model also reveals that increased co-movement of inflation and consumption leads to more volatile interest rates.

Suggested Citation

  • Illenin Kondo & Fabrizio Perri & Sewon Hur, 2016. "Inflation, Debt, and Default," 2016 Meeting Papers 1610, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:1610
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    6. Ricardo Sabbadini, 2017. "Overcoming the Original Sin: Gains from Local Currency External Debt," Working Papers, Department of Economics 2017_27, University of São Paulo (FEA-USP).

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    More about this item

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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