Default Risk on Government Bonds, Deflation, and Inflation

This paper analyzes the impact of deflation and inflation on the real interest rates of GBs using an overlapping generations model with the relationship between the real interest rate of GBs and the fiscal consolidation rule. We find that deflation may lower the real interest rate of GBs to the same level of public debt to capital, even if the fiscal consolidation rule is the same, as opposed to the conventional view that the real interest rate of GBs is determined independent of deflation if the Fisher equation holds. Our results are consistent with how the real interest rates of Japanese GBs react in periods of deflation. This paper also addresses the impact of fiscal inflation (i.e., monetizing all parts of the GB’s default using monetary policy). We calculate the expected fiscal inflation when the default rate in the event of fiscal consolidation is raised. The fiscal inflation may be extremely high if the extent of the required tax increase in fiscal consolidation is low. Initial inflation accelerates the expected fiscal inflation, but initial deflation suppresses it.Overlapping generations model, real interest rate, fiscal consolidation rule, default risk, fiscal inflation

Public Debt Accumulation and Fiscal Consolidation

In this paper, we analyze the relationship between interest rates on government bonds (GB) and fiscal consolidation rule by using an overlapping generation model with endogenous and stochastic growth settings. Our key findings are summarized as follows. First, interest rates of GB may be declining as public debt accumulates relative to private capital, as opposed to the conventional view that buildup of public debt accompanies a rise in interest rates. Second, fiscal consolidation rule plays a key role in determining interest rates in equilibrium. Third, the economy may exhibit discrete changes with interest rates diverging, implying that our observation of relatively low GB interest rates does not assure the continuation of that trend in the future. Fourth, a preventive tax increase to contain public debt at sustainable levels will not gain the political support of existing generations, whose life span is limited. Citizens prefer to shift the ultimate burden of public debt to future generations.Overlapping generation model, interest rate on government bond, fiscal consolidation rule, default risk