Default risk premia on government bonds in a quantitative macroeconomic model
Loading...
Date
2012-05-03
Journal Title
Journal ISSN
Volume Title
Publisher
Abstract
We develop a macroeconomic model where the government does not guarantee to repay
debt. We ask whether movements in the prices of government bonds can be rationalized
by lender's unwillingness to roll over debt when the outstanding debt level exceeds a
government's repayment capacity. Default occurs if a worsening state of the economy
leads to a build-up of debt that exceeds the government's ability to repay. Investors
are unwilling to engage in a Ponzi game and withdraw lending in this case and thus
force default at an endogenously determined fractional repayment rate. Interest rates on
government bonds reflect expectations of this event. We analytically show that there exist
two equilibrium bond prices. Our numerical analysis shows that, at moderate debt-to-gdp
levels, default premia hardly emerge in the low risk equilibrium. High risk premia can
either arise at high debt-to-gdp ratios, where even small changes in fundamentals lead to
steeply rising interest rates, or as realizations of the high risk equilibrium.
Description
Table of contents
Keywords
fiscal policy, government debt, multiple equilibria, sovereign default