Nominal Debt Research Articles

Surprise by Anticipated Inflation

This paper proposes a theoretical model with two types of households to explore the distributional effects of inflation, assess the non-neutrality of money; and in return, to provide a guideline for policymakers in setting inflation rate. An impatient borrower who faces a borrowing constraint holds a positive amount of debt in equilibrium while a patient lender engages in consumption smoothing. Hence, inflation affects net worth of borrowers via nominal debt by redistributing resources away from lender, rendering welfare gains for the borrower and losses for the lender; and the structure of borrowing constraint gives rise to non-neutrality of anticipated inflation. The utilitarian welfare gain from generating inflation in a cashless economy is amplified when heterogeneous productivity levels are assumed. Yet, incorporating money demand in the form of money-in-utility model suggests that an inflation tax as an additional distortion reverses the overall positive effect of generating inflation in the cashless economy. JEL Classifications: E31, E37, E41, E52, D63.

Welfare-enhancing inflation and liquidity premia

We investigate what principles should govern the evolution and maturity structure of the national debt when nominal government securities constitute an important form of exchange media. Even in the absence of government funding risk, we find a rationale for issuing nominal debt in different maturities, purposely mispricing long-term debt, and growing the nominal debt to support a strictly positive inflation target. The policy of discounting long-term debt and supporting a strictly positive inflation target provides superior risk-sharing arrangements for clienteles characterized by different degrees of patience. Pareto improvements are possible only if these policies are offered jointly.

Optimal public debt indexation in advanced economies

Abstract This article examines the cross-country heterogeneity in the share of advanced economies’ inflation-linked (IL) debt when governments, taking inflation as given, issue IL debt and nominal debt and aim to minimize tax distortions, debt investors are risk-neutral, and nominal debt carries a convenience premium. The optimal IL debt share increases in the level and the variance of inflation, decreases in the correlation between government spending and inflation, and, for a fixed level of debt, decreases in the nominal debt’s convenience premium. Data between 1995 and 2018 for 14 advanced economies that issue IL debt exhibit cross-country correlations in line with the model’s comparative statics about inflation. The model’s welfare analysis suggests that nominal debt’s convenience premium can explain the relatively low public debt indexation in most advanced economies.

INSIDE MONEY, INVESTMENT, AND UNCONVENTIONAL MONETARY POLICY

AbstractI develop a model where banks play a central role in monetary policy transmission. By credibly committing to repayment, banks can perform liquidity transformation. Illiquid assets may pay a liquidity premium because they allow banks to create liquid assets. The policy analysis discusses how the monetary authority can affect nominal rates and inflation when the fiscal authority follows nominal or real debt targets. A main result is that under a nominal debt target, the monetary authority is only able to increase inflation at the zero‐lower bound by issuing money via lump‐sum transfers, while doing so via bond purchases is ineffective.

Monetary Policy and Sovereign Debt Sustainability

Abstract We analyze the consequences of monetary policy for sovereign debt sustainability and welfare in a model of a small open economy where the government issues long-term nominal debt without a commitment not to default on it or erode its real value through (costly) inflation. Inflation is a form of partial default, one that is more state-contingent than outright default. This reduces the government’s incentives to default outright and hence enlarges the repayment region, compared to a regime in which debt cannot be inflated away. Moreover, inflation delivers sizable welfare gains in situations of sovereign debt stress, in which its benefits as a debt-stabilizing tool are larger. Over the longer run, however, the welfare gains from inflation are more modest, because the inflationary bias leads the government to create inflation also in situations in which it is less useful for debt-stabilization purposes.

High Inflation: Low Default Risk and Low Equity Valuations

AbstractWe develop an asset pricing model with endogenous corporate policies that explains how inflation jointly affects real asset prices and corporate default risk. Our model includes two empirically founded nominal rigidities: fixed nominal debt coupons (sticky leverage) and sticky cash flows. These two frictions result in lower real equity prices and credit spreads when expected inflation rises. A decrease in expected inflation has opposite effects, with even larger magnitudes. In the cross-section, the model predicts that the negative impact of higher expected inflation on real equity values is stronger for low leverage firms. We find empirical support for the model’s predictions.Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

When and Where Is It Cheaper to Issue Inflation-Linked Debt?

Abstract I compare the direct issuance costs of inflation-linked debt (the liquidity premium) with nominal government debt (the inflation risk premium) in developed countries. On average, it is cheaper to issue nominal debt at medium maturities (5–10 years) and inflation-linked debt at long maturities (20 or more years), although results vary somewhat based on whether survey-based or statistical inflation expectations are used. Issuance costs exhibit pronounced time and cross-country variation. Lower inflation-linked debt issuance costs are associated with more countercyclical inflation and higher proportions of inflation-linked debt. International inflation-linked zero-coupon yields are available as an Internet Appendix to this paper. (JEL E31, E43, G12, G15, H30, H63) Received November 22, 2018; editorial decision March 9, 2021 by Editor Jeffrey Pontiff. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Understanding China's role in recent debt relief operations: A case study analysis

China has been increasingly involved in debt restructurings for low- and middle-income countries. This paper presents case studies of China's debt relief actions overseas: Iraq (2003), Cuba (2010), Seychelles (2011), Chad (2017), Zambia (2018), Mozambique (2018), Cameroon (2019), Republic of Congo (2019) and Venezuela (in progress). These cases shed light on the commonalities and particularities of China's actions, and underline the evolution of its restructuring terms. We highlight the lack of formal coordination between China and other creditors. China almost exclusively made its own decision on providing restructurings and restructuring terms. The magnitude of China's debt relief actions remains generally limited and varies across countries, depending on whether other creditors have also provided debt restructurings. China seems to have a growing preference for cancellation of accumulated arrears to nominal debt principal reduction. The debt rescheduling cases have significantly increased in recent years as well. This evolution brings China closer to the flow treatment that the Paris Club privileged in its early years of operations and the prevailing practices among private creditors.

Inflating Away the Public Debt? An Empirical Assessment

Abstract This paper proposes a new method for measuring the impact of inflation on the real value of public debt. The distribution of debt debasement is based on two inputs: the distribution of privately held nominal debt by maturity, for which we provide new estimates, and the distribution of risk-adjusted inflation dynamics, for which we provide a novel copula estimator using options data. We find that inflation by itself is unlikely to lower the U.S. fiscal burden significantly because debt is concentrated at short maturities and perceived inflation shocks have little short-run persistence and are small.

Boosting fiscal space: the roles of GDP-linked debt and longer maturities

SUMMARYThis paper assesses how issuance of GDP-linked debt and longer-maturity debt, in comparison to short-term debt, can help boost fiscal space for a given path of primary balances. By explicitly linking debt service to repayment capacity, GDP-linked debt helps to stabilize the debt ratio under growth uncertainty and reduces default risk through risk sharing with investors. Longer-maturity nominal debt also helps reduce default risk via state-contingent variation in the market price of debt. Reduced default risk in both cases lowers borrowing costs and results in higher maximum sustainable debt levels (and fiscal space given initial debt) for a given path of primary balances. Simulation results suggest sizable gains in fiscal space from the introduction of these instruments, though debtor moral hazard could militate against these benefits.

Price Level Risk and Some Long-Run Implications of Alternative Monetary Policy Strategies

<ns2:p>This note focuses on the longer-run implications of alternative monetary policy strategies for the evolution of the price level. The analysis compares the properties of optimal policy in regimes ranging from pure inflation targeting (IT), to a form of weighted-average inflation targeting (WAIT), to pure price level targeting (PLT). Strategies such as WAIT and PLT tend to limit the downward drift in the path of the price level and also mitigate the uncertainty surrounding the expected path of the price level. The influence of alternative monetary policy strategies on the evolution of the price level may have some important long-run implications for entities or groups that rely heavily on long-term nominal debt. Some simple empirical estimates suggest the real value of existing Treasury debt could be boosted significantly in moving from a world in which the ZLB constraint rarely binds to one in which it regularly binds. Similarly, data from the Survey of Consumer Finances indicate that households at lower income levels, and particularly those with mortgage or educational loans outstanding, are exposed to significant price level risk. As a result, such households can experience a significant reduction in their real wealth, on average, in the transition to a world with frequently binding ZLB constraints. The WAIT and PLT regimes significantly mitigate these potential costs for these groups.</ns2:p>

Inflation, default and sovereign debt: The role of denomination and ownership

Emerging market governments hold mixed debt portfolios: They borrow at home and abroad in both nominal and real terms. This paper incorporates such a mixed debt structure into a theory of sovereign debt, default and inflation. The government optimally uses both default and inflation to balance its budget. The portfolio structure affects the relative benefits of inflation, default and incentives to accumulate debt. A calibrated version of the model can account for key features of the Mexican economy. We use the model to study if portfolio shifts away from purely real and external debt contributed to emerging market disinflation in the mid 1990s. We find that the answer depends on the distinction between ownership and denomination: Increasingly nominal debt is inflationary if held abroad, but lowers inflation if held at home.

Bailouts, Inflation, and Risk-Sharing in Monetary Unions

This paper presents a new rationalization for bailouts of sovereign debt in monetary unions, such as those observed during the recent Euro crisis. It introduces a model where member countries of the monetary union are ex-ante identical, and each derives utility from consumption and disutility from the union-wide inflation rate. The union’s central bank is utilitarian and lacks commitment. Countries borrow or save in a market for nominal sovereign debt in response to idiosyncratic income shocks, with countries that receive positive income shocks saving and countries that receive negative income shocks borrowing. Ex post, the monetary union’s central bank will attempt to devalue sovereign debt through surprise inflation, as this will redistribute income from rich creditor countries to poor debtor countries. Creditor countries choose to bailout debtor countries because bailouts will weaken the redistributive motives of the central bank and forestall surprise inflation. As bailouts in this environment constitute a payment from lucky creditor countries to unlucky debtor countries, they mimic a risk-sharing arrangement that insures against income shocks. The payments made by creditor countries are incentive-compatible due to the shared currency and inflation rate in the monetary union. This ability of countries to provide each other with incentive-compatible insurance constitutes a novel theory of optimal currency areas. This insurance benefit of the monetary union is largest for countries with negatively correlated income shocks, in contrast to the classic Mundell-Friedman optimal currency area criterion.

Nominal contracts and the payment system

This paper introduces into an overlapping generations model the civil court’s inability to distinguish different qualities of goods of the same kind. This friction prevents the enforcement of real credit contracts through the civil court. Given this environment, fiat money is introduced into the model as an intrinsically useless, but recognizable instrument for the court. With fiat money, there exists an equilibrium in which agents write pledgeable nominal debt contracts, while fiat money circulates as both a means of debt repayment and a means of payment for goods. This result does not require dynamic inefficiency or lack of double coincidence of wants. However, there can occur a shortage of real money balances for debt repayments, because lenders must pay fiat money for borrowers’ output before receiving the repayment of debt, in order for borrowers to obtain fiat money to repay debt. The central bank can resolve this bottleneck if it provides an elastic money supply through a discount window within each period. These results replicate two institutional features of the current monetary system—that is, fiat money being legal tender and a discount window offered by the central bank—in an unified framework.

A Macrofinance View of U.S. Sovereign CDS Premiums

ABSTRACTPremiums on U.S. sovereign credit default swaps (CDS) have risen to persistently elevated levels since the financial crisis. We examine whether these premiums reflect the probability of a fiscal default—a state in which a balanced budget can no longer be restored by raising taxes or eroding the real value of debt by increasing inflation. We develop an equilibrium macrofinance model in which the fiscal and monetary policy stances jointly endogenously determine nominal debt, taxes, inflation, and growth. We show that the CDS premiums reflect the endogenous risk‐adjusted probabilities of fiscal default. The calibrated model is consistent with elevated levels of CDS premiums but leaves dynamic implications quantitatively unresolved.

Inflation-default trade-off without a nominal anchor: The case of Greece

We investigate the debt sustainability implications of leaving a currency union in the context of the Grexit phenomenon. Using a common currency debt specification that is calibrated to the 2001-2010 episode of the Greek economy, we obtain default in year 2012 as an endogenous outcome in a baseline event analysis. Next, we consider a Grexit scenario in which the government issues both euro and drachma denominated sovereign debt and has the option to inflate away its nominal debt obligations by discretion. In the Grexit economy, lenders charge an ex ante inflation risk premium while buying drachma debt with the anticipation of an ex post inflationary bias. Consequently, in order to obtain drachma debt shares that are representative of the Greek economy in the pre-eurozone episode, we assume that the sovereign now borrows in segmented bond markets and the inflation risk premium on drachma debt is counterbalanced by a risk aversion premium asked by lenders of euro debt. We find that outright default would be avoided in 2012 if drachma was announced as a national currency. However, despite default is avoided, the aversion premium on euro debt shrinks the revenue raised by debt issuance in large amounts and reduces welfare.

Changes in Debt

Mainstream macroeconomists have a tendency to see debt as a flow variable, whereas heterodox economists emphasizes that debt should be understood as a stock-flow component in the economy. In this way changes in debt has to do with adjustments in assets and liabilities as well as in the servicing of interests. To bridge the interests a stock-flow model of debt changes is proposed. A sectoral approach is taken to debt changes underlining that debt is first of all a sectoral problem before becoming a total economy issue. The model is derived from the policy relevant indicator for debt, the nominal debt to nominal GDP. The resulting model show that debt changes are directly linked to changes in the real rate of interest and the real economic growth rate, and to the indirect effects of these changes on the net income and net asset positions of the economy’s sectors. The results are used to explain the recent surge in world debt levels and possible linkages to monetary policy.

China’s Debt Relief Actions Overseas and Macroeconomic Implications

We provide a novel database of 140 cases of official debt restructurings that China conducted between 2000 and 2019 in 64 debtor countries. The database shows that China has executed the majority of debt restructurings through debt forgiveness rather than through debt rescheduling, such as maturity extension and/or interest rate reduction. We also find that one third of China’s debt restructurings in the database took place within a four-year time frame of debt relief agreements with the Paris Club and that more than half of the restructurings were conducted in the context of a financial assistance programme from the International Monetary Fund. Using local projections, we find a negative impact of China’s debt restructurings on growth and development prospects in debtor countries, especially when China provides debt rescheduling and does not reduce the stock of nominal debt. Subdued domestic fixed capital investment and fiscal policy tightening seem to be the main drags on economic growth in debtor countries after a restructuring.

Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy

Nominal debt provides consumption-smoothing benefits if it can be inflated away during recessions. However, we document empirically that countries with more countercyclical inflation, where nominal debt provides better consumption-smoothing, issue more foreign-currency debt. We propose that monetary policy credibility explains the currency composition of sovereign debt and nominal bond risks in the presence of risk-averse investors. In our model, low credibility governments inflate during recessions, generating excessively countercyclical inflation in addition to the standard inflationary bias. With countercyclical inflation, investors require risk premia on nominal debt, making nominal debt issuance costly for low credibility governments. We provide empirical support for this mechanism, showing that countries with higher nominal bond-stock betas have significantly larger nominal bond risk premia and borrow less in local currency.

Inflation, Debt, and Default

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.