Nominal Debt Research Articles

Optimal Maturity of Nominal Government Debt: An Infinite-Horizon Model

The role of debt maturity is analyzed in a framework that blends tax smoothing with time inconsistency of optimal policy when policymakers have an incentive to use unanticipated inflation to reduce the real value of nominal government liabilities. Three conclusions emerge: (1) nominal debt leads policymakers to resort to inflation even though, in equilibrium, inflation collects no revenue; (2) when under full precommitment the optimal policy calls for complete tax smoothing and a constant debt level, the equilibrium policy without precommitment calls for anticipating tax collection and early debt repayment; and (3) management of debt maturity is an essential component of the equilibrium policy. Copyright 1992 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Debt write-downs and debt—equity swaps in a two-sector model

‘Debt overhang’ models have motivated the possibility of Pareto-improving market-based debt-reduction schemes through the assumption that creditors can seize debtor output under default. These models usually reach the conclusion that both debtor-financed debt repurchases and debt-equity swaps are not in the interest of debtor nations. This paper re-examines these conclusions for a debtor nation that also has a ‘safe sector’ which is unexposed to seizure. Debt overhangs are then shown to distort the composition of investment in the debtor nation. Nominal debt reductions mitigate these distortions, enhancing the potential for Pareto-improving debt-equity swaps.

Market Valuation of Illiquid Debt and Implications for Conflicts among Creditors

We develop a formula for the market value of debt when the borrower's repayment capacity varies stochastically and shortfalls are rolled over. The value of a marginal dollar of nominal claim is an S-shaped function of the ratio of the repayment capacity to the amount of nominal debt. Shifts of this curve are examined in response to changes in the underlying parameters. The calculations bring out conflicts of interest among lenders of differing degrees of seniority. Most surprisingly, junior creditors gain when the loan is rescheduled on terms more favorable to the debtor.

Time consistency of monetary policy in the open economy

This paper shows that in an open economy time-consistency problems are created not only by nominal government debt, but also by nominal private debt to foreigners. Given any external nominal debt, inflation redistributes wealth between domestic residents and foreigners. A government that cares about the welfare of its residents will be tempted to inflate whenever it or its residents have issued nominal debt to foreigners. An analysis of the U.S. net investment position shows that these international considerations have become increasingly relevant for the United States, because the recent external deficits have largely been financed in nominal terms.

Credibility and Nominal Debt: Exploring the Role of Maturity in Managing Inflation

The role of debt maturity in managing the government's incentives to use opportunistic inflation to reduce the ex post real value of its nominal liabilities is explored. The maturity structure of government debt is shown to be a powerful instrument for affecting the time profile of the inflation tax base and, hence, for mitigating the distortions introduced by time inconsistency on taxation policies. The nature of the optimal policy is shown to be heavily dependent on the type of precommitment enjoyed by policymakers.

Market Valuation of Illiquid Debt and Implications for Conflicts Among Creditors

We develop a formula for the market value of debt when the borrower’s repayment capacity varies stochastically, and shortfalls are rolled over. The value of a marginal dollar of nominal claim is an S-shaped function of the ratio of the repayment capacity to the amount of nominal debt. Shifts of this curve are examined in response to changes in the underlying parameters. The calculations bring out some conflicts of interest among lenders of differing degrees of seniority. Most surprisingly, junior creditors gain when the loan is rescheduled on terms more favorable to the debtor.

Market Valuation of Illiquid Debt and Implications for Conflicts Among Creditors

We develop a formula for the market value of debt when the borrower’s repayment capacity varies stochastically, and shortfalls are rolled over. The value of a marginal dollar of nominal claim is an S-shaped function of the ratio of the repayment capacity to the amount of nominal debt. Shifts of this curve are examined in response to changes in the underlying parameters. The calculations bring out some conflicts of interest among lenders of differing degrees of seniority. Most surprisingly, junior creditors gain when the loan is rescheduled on terms more favorable to the debtor.

Is Inflation Effective for Liquidating Short-Term Nominal Debt?

The possibility of reducing the real value of domestic nonindexed government debt through inflation is studied. A central result is that this kind of debt liquidation is possible even though prices are sticky and government bonds are short term. A policy implication is that short bond maturities are no safeguard against surprise devaluations intended to lower the burden of the debt. If devaluation incentives are present, nominal nonindexed bonds could give rise to situations in which devaluations are a consequence of self-fulfilling expectations cycles.

Credibility and Nominal Debt: Exploring the Role of Maturity in Managing Inflation

This paper focuses on the role of debt maturity in managing the government`s incentives to use opportunistic inflation to reduce the ex post real value of its nominal liabilities. The maturity structure of government debt is shown to be a powerful instrument to affect the time profile of the inflation tax base and, hence, to mitigate the distortions introduced by time inconsistency on taxation policies. The nature of the optimal policy is shown to be heavily dependent on the type of precommitment enjoyed by policymakers.

Credibility and Nominal Debt: Exploring the Role of Maturity in Managing Inflation

Credibility and Nominal Debt: Exploring the Role of Maturity in Managing Inflation

Is Inflation Effective for Liquidating Short-Term Nominal Debt?

Is Inflation Effective for Liquidating Short-Term Nominal Debt?

Is Inflation Effective for Liquidating Short-Term Nominal Debt?

Is Inflation Effective for Liquidating Short-Term Nominal Debt?

Why do we have nominal government debt?

We study the choice between nominal and indexed debt in a stochastic macroeconomic model with discretionary monetary and fiscal policy. With distortionary taxes, nominal debt provides valuable insurance against the budgetary effects of economic fluctuations. We show that a welfare-maximizing government always issues some nominal debt even though nominal debt increases inflation along the time-consistent path of the economy. The result is fairly robust with respect to changes in assumptions about policy constraints and about the macroeconomic setting.

AGGREGATE DEMAND CONTRACTIONS WITH NOMINAL DEBT COMMITMENTS: IS WAGE FLEXIBILITY STABILIZING?

When nominal debt payments commitments exist, output losses following an aggregate demand contraction will be larger and more persistent. Paradoxically, output can be less stable if wages are more flexible. This occurs because falling wages and prices cause debtors' cash flow to deteriorate relative to their debt commitments. To reduce the chance of incurring bankruptcy costs, debtors cut expenditure. Creditor's wealth increases from an unexpected deflation but their gain does not offset debtors' loss because of the increased threat of bankruptcy and associated costs. Net wealth and aggregate demand fall, magnifying the effect of the initial contraction.

Interest rate smoothing and price level trend-stationarity

This paper discusses the definition and mechanics of central bank interest rate smoothing under rational expectations. A tension arising between interest rate smoothing and macroeconomic stabilization objectives induces non-trend-stationary price level and money stock behavior. The paper thereby helps explain why such nominal non-stationarities are widely observed. Further implications are drawn for base drift, distribution of real returns on long-term fixed-rate nominal debt, and operating characteristics of interest rate pegs and policy instruments.

Alternative Financial Policy Rules in an Open Economy Under Rational and Adaptive Expectations

The potential instability of a fixed monetary rule combined with automatic fixed stabilisers is a well-established feature of closed economy IS/LM models with wealth effects and asset accumulation. This paper examines the stability issue in a general open economy macromodel with alternative expectations mechanisms (rational or adaptive) in both the labour market and the foreign exchange market. The fixed monetary rule is found to be stabilising only in special cases, notably when post-tax real interest rates are negative and the foreign exchange market is characterised by high capital mobility and rational expectations. By contrast, the alternative rule of fixing the rate of growth of nominal government debt is stable for a wide range of parameter values and alternative expectations schemes.

The Information Content of Indexed Bonds

THE INFORMATIVE ROLE OF ASSET MARKETS HAS RECENTLY been emphasized by Barro (1980), Karni (1980), Weiss (1982), Grossman and Weiss (1982), King (1983), and Dotsey and King (1983) in the context of incomplete information, equilibrium business cycle models. An implication of the notion that asset markets are informative is that public finance policy concerning real and nominal debt issuance effects macroeconomic equilibrium through the information content of real and nomlnal bond prices. This paper focuses on inferences about unperceived economic shocks when all agents observe prices in both economy-wide indexed and nominal bond markets. In this framework indexed bond prices help determine perceptions about relative and aggregate disturbances that, in turn, influence the market-clearing value of aggregate output. The analysis of the information content of government-issued indexed bonds is motivated by the following considerations. First, to the extent that incomplete information plays a causal role in business cycles, it is important to examine policies that alter the contemporaneous information available to private agents in making production-employment decisions. While the previous literature, cited above, has made a theoretical case for the proposition that asset markets are informative, as yet there have been few attempts to investigate government finance policies suggested by this proposition. The issuance of real or nominal bonds is perhaps the most dramatic way that government finance policy can affect the information structure of

THE DETERMINANTS OF THE PUBLIC DEBT IN THE UNITED STATES, 1953–1978

Barro claims that since the public rationally forecasts and discounts future taxes, government debt does not represent net wealth to the public and therefore does not affect any real economic variables. Then why are there ever deficits? Barro has presented a theory of optimal deficits based on intertemporal tax smoothing. The theory predicts that nominal debt grows in proportion to anticipated inflation, varies contracyclically with respect to real income cycles, and varies procyclically with respect to war cycles. Barro tested his theory using annual American data for 1922‐76 and found weak support for his theory. This paper reexamines Barro's tests, using quarterly American data for 1953:Q1 to 1978:Q4 and finds stronger support for Barro's theory than Barro found using annual data. This paper also concludes that state and local governments do not engage in tax‐smoothing behavior–––probably due to considerations of migration–––and that the debt held by the central bank should be included in the definition of public debt.

Correction: An Increasing Annuity Based on Nominal Interest Rates and Debt Instruments

Correction: An Increasing Annuity Based on Nominal Interest Rates and Debt Instruments

Currency Risk and Relative Price Risk

This paper demonstrates the strong linkages that exist between currency risk, represented by inflation risk and exchange rate changes, and relative price risk. These linkages affect the optional quantities of forward exchange contracts, nominal debt, and fixed price sales (purchase) contracts to use in hedging against these risks. It is shown that the existence of as many hedging mechanisms as there are forms of price risk allows for the precise targeting of specific price risks with specific hedging instruments. Moreover, even though each hedging mechanism specializes in protecting against a particular form of price risk, the optimal quantitiy of each influences and is influenced by the optimal quantities of the others.