Inflation, External Default, and the Composition of Sovereign Debt

Abstract

This paper extends the sovereign default model described in Arellano (2008) by including both domestic and foreign debts. The government issues debt and can either inflate away its domestic debt or default on its external component. Under a discretionary policy, the existence of domestic debt creates a costly inflation bias. On the other hand, the cost of foreign debt increases with the quantity of debt issued due to the increasing likelihood of default. This tradeoff between inflation and external default costs drives the dynamics of the domestic/foreign composition of sovereign debt. This model demonstrates the role of domestic debt in explaining why some emerging market countries tend to default on low levels of foreign debt-to-GDP ratios. The model also proposes a new channel justifying why inflation hikes occur before external default episodes.

Keywords: sovereign debt, inflation, sovereign default