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Federal Reserve Bank of Cleveland
Working Papers (Old Series)
Inflation, Debt, and Default
Sewon Hur
Illenin O. Kondo
Fabrizio Perri
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.


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Sewon Hur & Illenin O. Kondo & Fabrizio Perri, Inflation, Debt, and Default, Federal Reserve Bank of Cleveland, Working Papers (Old Series) 1812, 28 Sep 2018.
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Keywords: inflation risk; domestic nominal debt; interest rates; sovereign default
DOI: 10.26509/frbc-wp-201812
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