Abstract:

When public debt is issued in domestic currency, any sudden confidence crisis in the re-
payment ability of the government need not trigger a default, since it can be accommodated
by temporary monetary financing, converting default risk into inflation risk. When the de-
fault risk premium is determined by well-informed financial intermediaries while inflation
arises from the choices of less-informed workers and producers, this conversion masks ad-
verse news, at least temporarily, and results in lower interest rates following adverse shocks.
In this paper, we assess the importance of this channel, and the extent to which it is eroded
when persistent fiscal shortfalls shift the prior held by all agents in the economy about the
eventual resolution of the imbalance.