Inflation, Debt, and Default

49 Pages Posted: 11 Oct 2018

See all articles by Sewon Hur

Sewon Hur

Federal Reserve Bank of Dallas

Illenin Kondo

University of Notre Dame

Fabrizio Perri

Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Date Written: September 28, 2018

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.

Keywords: inflation risk, domestic nominal debt, interest rates, sovereign default

JEL Classification: E31, F34, G12, H63

Suggested Citation

Hur, Sewon and Kondo, Illenin and Perri, Fabrizio, Inflation, Debt, and Default (September 28, 2018). FRB of Cleveland Working Paper No. 18-12, Available at SSRN: https://ssrn.com/abstract=3259649 or http://dx.doi.org/10.2139/ssrn.3259649

Sewon Hur (Contact Author)

Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Illenin Kondo

University of Notre Dame

361 Mendoza College of Business
Notre Dame, IN 46556-5646
United States

Fabrizio Perri

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

90 Hennepin Avenue
Minneapolis, MN 55480
United States

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