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.