Abstract
This paper makes a case for foreign currency debt as a hedging device in an open economy subject to stochastic shocks to output. A government can reduce uncertainty in wealth and in consumption by issuing foreign or domestic currency debt if unexpected domestic and foreign inflation are negatively correlated with domestic output. Foreign currency debt is desirable in comparison to domestic currency debt if growth rates of output of both countries are closely related and if domestic inflation is relatively uncertain. It has an additional advantage if domestic debt creates time-consistency problems.
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