Date Added: Jan 2010
A number of countries have issued sovereign debt bonds indexed to real variables in recent years. In a dynamic stochastic equilibrium framework with incomplete markets, this paper studies the main features that a well-designed real-indexed contract should have to improve risk sharing and diminish the probability of debt crises. The authors use the framework to quantify the magnitude of the welfare effect that this type of instruments could generate. They show that a well-designed indexed debt contract should feature payments increasing in the state of the economy and generate, in combination with the assets held by the government, a pattern of payoffs similar to that of an insurance contract.