Crisis and Commitment: Inflation Credibility and the Vulnerability to Sovereign Debt Crises

53 Pages Posted: 11 Oct 2013 Last revised: 17 Oct 2013

See all articles by Mark Aguiar

Mark Aguiar

Princeton University

Manuel Amador

Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Emmanuel Farhi

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Gita Gopinath

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: October 2013

Abstract

We propose a continuous time model of nominal debt and investigate the role of inflation credibility in the potential for self-fulfilling debt crises. Inflation is costly, but reduces the real value of outstanding debt without the full punishment of default. With high inflation credibility, which can be interpreted as joining a monetary union or issuing foreign currency debt, debt is effectively real. By contrast, with low inflation credibility, sovereign debt is nominal and in a debt crisis a government may opt to inflate away a fraction of the debt burden rather than explicitly default. This flexibility potentially reduces the country's exposure to self-fulfilling crises. On the other hand, the government lacks credibility not to inflate in the absence of crisis. This latter channel raises the cost of debt in tranquil periods and makes default more attractive in the event of a crisis, increasing the country's vulnerability. We characterize the interaction of these two forces. We show that there is an intermediate inflation credibility that minimizes the country's exposure to rollover risk. Low inflation credibility brings the worst of both worlds--high inflation in tranquil periods and increased vulnerability to a crisis.

Suggested Citation

Aguiar, Mark and Amador, Manuel and Farhi, Emmanuel and Gopinath, Gita, Crisis and Commitment: Inflation Credibility and the Vulnerability to Sovereign Debt Crises (October 2013). NBER Working Paper No. w19516, Available at SSRN: https://ssrn.com/abstract=2338889

Mark Aguiar (Contact Author)

Princeton University ( email )

Princeton, NJ 08544-1021
United States

Manuel Amador

Federal Reserve Banks - Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

Emmanuel Farhi

Harvard University - Department of Economics ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Gita Gopinath

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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