Abstract:
We explore the role of inflation credibility in self-fulfilling debt crises. In particular,
We propose a continuous time model of nominal debt with the potential for self-
fulfilling debt crises as in Calvo (1988) and Cole and Kehoe (2000). We characterize
crisis equilibria conditional on the level of commitment to low inflation. With strong
commitment, which can be interpreted as joining a monetary union or issuing foreign
currency debt, the environment is a version of the one studied by Cole and Kehoe.
The paper contrasts this framework with one in which sovereign debt is nominal and
is vulnerable to ex post devaluation. Inflation is costly, but reduces the real value of
outstanding debt without the full punishment of default. In a debt crisis, a government
may opt to inflate away a fraction of the real debt burden rather than explicitly default.
This flexibility potentially reduces the country's exposure to self-fulfilling crises.
On the other hand, the government lacks commitment not to inflate in the absence of
crisis. This latter channel raises the cost of debt in tranquil periods and makes default
more attractive in the event of a crisis, increasing the country's vulnerability. We characterize
the interaction of these two forces. We show that there is an intermediate level
of commitment that minimizes the country's exposure to rollover risk. On the other
hand, low inflation credibility brings the worst of both worlds --high inflation in tranquil
periods and increased vulnerability to a crisis. Weak inflationary commitment also
reduces the country's equilibrium borrowing limit. These latter results shed light on
the notions of original sin and debt intolerance highlighted in the empirical literature;
that is, the fact that developing economies issue debt exclusive in foreign currency to
international investors as well as encounter solvency issues at relatively low ratios of
debt-to-GDP.