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Is Inflation Default? The Role of Information in Debt Crises

Author

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  • 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. Javier Bianchi & Jorge Mondragon, 2018. "Monetary Independence and Rollover Crises," NBER Working Papers 25340, National Bureau of Economic Research, Inc.
    2. Farboodi, Maryam & Veldkamp, Laura, 2018. "Long Run Growth of Financial Data Technology," CEPR Discussion Papers 13278, C.E.P.R. Discussion Papers.
    3. Albagli, Elias & Hellwig, Christian & Tsyvinski, Aleh, 2021. "Dispersed Information and Asset Prices," TSE Working Papers 21-1172, Toulouse School of Economics (TSE).
    4. Teupe, Sebastian, 2020. "Keynes, Inflation, and the Public Debt: "How to Pay for the War" as a Policy Prescription for Financial Repression?," Working Papers 16, German Research Foundation's Priority Programme 1859 "Experience and Expectation. Historical Foundations of Economic Behaviour", Humboldt University Berlin.
    5. 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.
    6. Albagli, Elias & Hellwig, Christian & Tsyvinski, Aleh, 2021. "Dispersed Information and Asset Prices," TSE Working Papers 21-1172, Toulouse School of Economics (TSE).

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    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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