Journal Article

On the benefits of GDP-indexed government debt: lessons from a model of sovereign defaults

Abstract: Whether governments should issue GDP-indexed sovereign debt continues to be the subject of policy debates. This article contributes to this debate by studying the effects of issuing GDP-indexed sovereign debt contracts using the equilibrium default model studied by Aguiar and Gopinath (2006) and Arellano (2008). We consider an extension with perfect indexation, i.e., the government issues Arrow-Debreu securities with payoffs that depend on the next-period aggregate income realization. The ex-ante welfare gain from the introduction of income-indexed bonds is equivalent to a permanent increase in consumption of 0.5 percent. Introducing income-indexed bonds results in welfare gains because it 1) eliminates defaults, 2) increases the average level of debt, and 3) reduces the volatility of consumption.

Keywords: Financial markets;

Bibliographic Information

Provider: Federal Reserve Bank of Richmond

Part of Series: Economic Quarterly

Publication Date: 2012

Volume: 98

Issue: 2Q

Pages: 139-157