Working Paper

Inflation, Debt, and Default


Abstract: We study how the co-movement of inflation and economic activity affects real interest rates and the likelihood of debt crises. First, we show that for advanced economies, periods with procyclical inflation are associated with lower real interest rates. Procyclical inflation implies that nominal bonds pay out more in bad times, making them a good hedge against aggregate risk. However, such procyclicality also increases sovereign default risk when the economy deteriorates, since the government needs to make larger (real) payments. In order to evaluate both effects, we develop a model of sovereign default on domestic nominal debt with exogenous inflation risk and domestic risk-averse lenders. Countercyclical inflation is a substitute with default, while procyclical inflation is a complement with it, by increasing default incentives. In good times, when default is unlikely, procyclical inflation yields lower real rates. In bad times, as default becomes more material, procyclical inflation can magnify default risk and trigger an increase in real rates.

Keywords: sovereign default; interest rates; domestic nominal debt; inflation risk;

JEL Classification: E31; F34; H63; G12;

https://doi.org/10.26509/frbc-wp-201812

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Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers (Old Series)

Publication Date: 2018-09-28

Number: 1812

Pages: 49 pages