Working Paper: NBER ID: w13131
Authors: Laura Alfaro; Fabio Kanczuk
Abstract: The main arguments in favor and against nominal and indexed debt are the incentive to default through inflation versus hedging against unforeseen shocks. We model and calibrate these arguments to assess their quantitative importance. We use a dynamic equilibrium model with tax distortion, government outlays uncertainty, and contingent-debt service. Our framework also recognizes that contingent debt can be associated with incentive problems and lack of commitment. Thus, the benefits of unexpected inflation are tempered by higher interest rates. We obtain that costs from inflation more than offset the benefits from reducing tax distortions. We further discuss sustainability of nominal debt in developing (volatile) countries.
Keywords: nominal debt; indexed debt; sovereign debt; inflation; fiscal policy
JEL Codes: E6; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| nominal debt (H63) | hedge against unforeseen fiscal shocks (H68) |
| indexed debt (G12) | eliminates incentive to inflate economy (E31) |
| nominal debt (H63) | higher future interest rates (E43) |
| higher future interest rates (E43) | increased uncertainty about government type (D89) |
| increased uncertainty about government type (D89) | influences future debt sustainability (H63) |
| nominal debt (H63) | inflation costs outweigh benefits of tax smoothing (E31) |
| Brazilian government's struggle to reduce indexed debt levels (H63) | high inflation history (E31) |
| high inflation history (E31) | time-inconsistency problem (D15) |
| time-inconsistency problem (D15) | complicates sustainability of nominal debt (H63) |
| transition from nominal to indexed debt (H63) | substantial losses if gradual (G33) |
| transition from nominal to indexed debt (H63) | potential benefits if swift (D61) |