Real Interest Rates, Inflation, and Default

55 Pages Posted: 17 Dec 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: December 2018

Abstract

This paper argues that the comovement between inflation and economic activity is an important determinant of real interest rates over time and across countries. First, we show that for advanced economies, periods with more procyclical inflation are associated with lower real rates, but only when there is no risk of default on government debt. Second, we present a model of nominal sovereign debt with domestic risk-averse lenders. With procyclical inflation, nominal bonds pay out more in bad times, making them a good hedge against aggregate risk. In the absence of default risk, procyclical inflation yields lower real rates. However, procyclicality implies that the government needs to make larger (real) payments when the economy deteriorates, which could increase default risk and trigger an increase in real rates. The patterns of real rates predicted by the model are quantitatively consistent with those documented in the data.

Keywords: Government Debt, Inflation risk, nominal bonds, sovereign default

JEL Classification: E31, F34, G12, H63

Suggested Citation

Hur, Sewon and Kondo, Illenin and Perri, Fabrizio, Real Interest Rates, Inflation, and Default (December 2018). CEPR Discussion Paper No. DP13388, Available at SSRN: https://ssrn.com/abstract=3302631

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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