Sovereign Default and the Decline in Interest Rates
66 Pages Posted: 8 Sep 2020 Last revised: 1 Feb 2021
Date Written: September 3, 2020
Sovereign debt yields have declined dramatically over the last half-century. Standard explanations for this decline, including aging populations and increases in asset demand from abroad, encounter difficulties when confronted with the full range of evidence across asset classes. We propose instead that the decline in inflation and default risk caused falling interest rates, a phenomenon that is not unique to our century. We show that a model with investment, inventory storage, and sovereign default captures the decline in interest rates, the stability of equity valuation ratios, and the recent reduction in investment and output growth corresponding to the zero lower bound.
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