Date Added: Mar 2010
The main arguments in favor and against nominal and indexed debt are the incentive to default through inflation versus hedging against unforeseen shocks. The authors model and calibrate these arguments to assess their quantitative importance. They use a dynamic equilibrium model with tax distortion, government outlays uncertainty, and contingent-debt service. The framework also recognizes that contingent debt can be associated with incentive problems and lack of commitment. Thus, the benefits of unexpected inflation are tempered by higher interest rates. They obtain that costs from inflation more than offset the benefits from reducing tax distortions. They further discuss sustainability of nominal debt in developing (volatile) countries.