Real Interest Rates, Inflation, and Default

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.

Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy

“…Hur, Kondo, and Perri (2018) consider the effect of exogenous inflation cyclicality on real interest rates in a model with endogenous sovereign default risk.…”

Optimal Bailouts in Banking and Sovereign Crises

“…The household and government's discount factor is set to 0.81 to match a default probability of 0.5 percent. Since our analysis mainly focuses on the European periphery, our target default probability of 0.5 percent is lower than that used for emerging economies (Aguiar et al 2016) and higher than that for advanced economies (Hur et al 2018). 7 Government spending, g, is set to 0.15 to match the median government consumption share of GDP of 19.1 percent in GIIPS (1999GIIPS ( -2019.…”

Optimal Bailouts in Banking and Sovereign Crises

“…The household and government's discount factor is set to 0.81 to match a default probability of 0.5 percent. Since our analysis mainly focuses on the European periphery, our target default probability of 0.5 percent is lower than that used for emerging economies (Aguiar, Chatterjee, Cole and Stangebye 2016) and higher than that for advanced economies (Hur, Kondo and Perri 2018). 7 Government spending, g, is set to 0.15 to match the median government consumption share of GDP of 19.1 percent in GIIPS (1999GIIPS ( -2019.…”