Understanding default risk premia on public debt
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Date
2010-06-18
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Abstract
We model the pricing of public debt in a quantitative macroeconomic model with government default risk. Default occurs if a shift in the 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. There may exist multiple bond prices compatible with a
rational expectations equilibrium. At high debt-to-output ratios, small changes in fundamentals lead to steeply rising risk premia. Key determinants of the level of indebtedness
at which this occurs are the perceived amount of aggregate risk, the feasibility of revenue
maximizing tax rates, and the maturity of bonds.
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Keywords
Asset pricing, Fiscal policy, Government debt, Sovereign default fiscal policy