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Is Inflation Default? The Role of Information in Debt Crises

Author

Listed:
  • Carlo Galli

    (University College London)

  • Marco Bassetto

    (Federal Reserve Bank of Chicago)

Abstract

In the aftermath of the financial crisis, countries which had control over their monetary policy, such as the United States, the United Kingdom, and Japan, were able to borrow at extremely low rates, even though they experienced very high deficit/GDP ratios (the UK) or debt/GDP ratios (Japan). In contrast, peripheral Eurozone countries with a high deficit/GDP ratio (Spain) or a high debt/GDP ratio (Italy) faced volatile interest rates. In a frictionless benchmark, default and inflation have the same economic effect. Creditors care about the real rate of return on their investment: whether they anticipate losing money to default or inflation, they will require an identical interest rate spread over risk-free bonds. We break this equivalence by introducing two classes of heterogeneously informed agents: bondholders, who decide whether to roll over their credit, and workers, who decide whether to accept currency in payment for their services. Domestic and foreign-currency borrowing are now distinguished by the identity of the marginal agent who triggers a crisis. We show conditions under which domestic-currency debt makes the economy more resilient to fiscal shocks.

Suggested Citation

  • Carlo Galli & Marco Bassetto, 2016. "Is Inflation Default? The Role of Information in Debt Crises," 2016 Meeting Papers 308, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:308
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    References listed on IDEAS

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    Cited by:

    1. Bianchi, Javier & Mondragon, Jorge, 2018. "Monetary Independence and Rollover Crises," Working Papers 755, Federal Reserve Bank of Minneapolis.
    2. Farboodi, Maryam & Veldkamp, Laura, 2018. "Long Run Growth of Financial Data Technology," CEPR Discussion Papers 13278, C.E.P.R. Discussion Papers.
    3. Maryam Farboodi & Laura Veldkamp, 2018. "Long Run Growth of Financial Data Technology," Working Papers 18-09, New York University, Leonard N. Stern School of Business, Department of Economics.

    More about this item

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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