American Economic Association

Servicing the Public Debt: The Role of Expectations Author(s): Guillermo A. Calvo Reviewed work(s): Source: The American Economic Review, Vol. 78, No. 4 (Sep., 1988), pp. 647-661 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1811165 . Accessed: 21/02/2013 14:30
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Servicing the Public Debt: The Role of Expectations

By GUILLERMOA. CALVO*
- is - openlyor through inflation We studymodelsin whichdebt repudiation the utility of therepresentative maximizes possible. The government individual, type.We show oftheBarro-Gordon equilibria and wefocuson no-precommitment perfect-forebondsgenerate multiple of government theexistence cases in which ceilingsare price indexationand/or interest-rate sight equilibria.However, solutions problem. multiplicity oftheequilibrium shownto bepossible

As one looks around the world one is of languages, impressedby the wide variety of the same cultures,and even perceptions phenomena. However, the topic of the budget is one of the fewwhere government the range of issues and degreeof emotions The appears to finda commondenominator. budgetlies at thebasis of politigovernment role in cal campaignsand plays a significant policy. the evaluationof government Recently,economic theoryhas begun to catch up with political realityby not only of fiscaland monethe optimality studying tary policy in a context where explicit budget account is takenof thegovernment's constraint-the cradle of political disputes by examin-but it has gone a step further of optimal policy, ing the time consistency it is optimalto that is, the issue of whether keep promisesthatwereoptimalto make in the past (for example, duringthe electoral
*University of Pennsylvania, Philadelphia, PA 19104-6297. I have greatlybenefitedfromcomments UniGeorgetown receivedat JohnsHopkinsUniversity, of the Macro Lunch Group of the University versity, Pennsylvania,MIT, and the Research Departmentof the InternationalMonetary Fund. I am particularly indebted to Matt Canzoneri,Sara Guerschanik-Calvo, Joseph Harrington, Jr., Elhanan Helpman, Nissan Leviatan, Maury Obstfeld,Assaf Razin, Sweder van The research referees. and two anonymous Wijnbergen, on this paper was partlydone while I was a visiting of theInternational scholarat theResearchDepartment Monetary Fund, and it was partiallyfunded by the National Science Foundation. However, any opinions myown and not thoseof any of expressedare entirely the above institutions. 647

campaign). The latterlies at theheartof the "credibility"dilemma faced by any serious politician. of optimalpolicy has Time inconsistency received a lot of attentionin the literature (see, for example, Finn Kydland and Edward Prescott, 1977; Guillermo Calvo, 1978a,b; Robert Barro and David Gordon, 1983a,b; Robert Lucas, Jr., and Nancy Stokey, 1983; Mats Persson,Torsten Pers1987,amongothers). son, and Lars Svensson, was directed however, Most of the attention, of the factorsreto (a) the identification (b) mechasponsible for timeinconsistency, and (c) the nismsto ensuretimeconsistency, of optimalpolicywhenprecharacterization sent plannerstake into account theirinability to make future commitments-which leads to the equilibriumconcept firstexamined in macroeconomics by Edmund Phelps and Robert Pollak, 1968). The latter conhas become the dominantequilibrium (see KennethRogoff, cept in this literature 1987). Phelps-Polak equilibriawere studied and in severalinfluential developed much further articles(for example,Kydland and Prescott, 1977; Barro and Gordon, 1983a,b); most of exhibitunique equithe examples,however, was menlibriumsolutions.Non-uniqueness tioned in Phelps (1975) and Calvo (1978b), and is one of the centralsubjectsof recent horimodels withan infinite game-theoretic zon (see Rogoff,1987), but, in all fairness, tends it must be said that non-uniqueness possibility to be deemed more a theoretical

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-reflecting,perhaps,the factthatthe models are not entirely correct-ratherthan a characteristic of empirically relevant models. The central topic of these notes is the discussionof a set of empirically motivated examples where non-uniqueness of PhelpsPollak equilibria is clearly exhibited.The possible empirical relevance of the nonuniquenessissue becomesapparentwhenexaminingthe role of interest-bearing government debt. The events of the 1970s and 1980s suggestverystrongly that when governmentsbecome strapped for funds,they tendto relymoreheavily on bonds' issuance. In fact,Barro (1979) suggests that this may even be optimal if governments are faced witha temporary incomefallor a temporary increase in government expenditures. However,the consequenttaxationpostponement is not freefrom"credibility" problems:Will the additional debt be paid offin full,will the government findit optimal to resortto higherinflationor currency devaluationto diminishthe burdenof the debt,etc.?When these questions are posed in termsof more precise language they translate into the following: Is debt repudiation-directly, interest rate taxes (say), or indirectthrough ly through inflation-a characteristicof Phelps-Pollakequilibria?Some answerscan be foundin StanleyFischer,1983; Henning Bohn, 1987; Herschel Grossman and John Van Huyck,1987; and literature on sovereign countries' debt (see the recent surveyby Jonathan and Joseph Eaton, MarkGersovitz, Stiglitz,1986). In this paper we pursue the discussionenquiring, whether the specifically, mere existence of government obligations may not be responsibleforthe existenceof multiple Phelps-Pollakequilibria. This appears likely to happen because expected would tend to be (partial) debt repudiation in the interest reflected rate on government bonds (increasingit), while the higherthe burden of the debt,the higher would be the to repudiate it. Thus,it shouldbe temptation withlow possible to generatean equilibrium interest and low repudiation, with coexisting a high-interest, high-repudiation equilibrium. Our examplesgivea strong supportto the above conjecture: Multiple solutions are possible even when our examplesassume a

finitehorizon,and the existenceof governfactorfor mentbonds may be the triggering non-uniqueness. The implications for policy could be thatpostsuggest for,our results staggering; poning taxes (i.e., falling into debt) may it may, generatethe seeds of indeterminacy; in which a situation in otherwords,generate the effectsof policy are at the mercyof people's expectations-gone would be the hopes of leading theeconomyalong an "optimal" path. we willfirst For thesake of theexposition, of nonmonetary discuss theseissues in terms individual. models with one representative In Section I we will examine a two-period model, where the debt is contractedin the first period and repaid in the second; taxes are distortingand, hence, the government has an incentiveto renegeon the debt. In order to get an equilibriumwith positive public debt,we assumethatdebtrepudiation to is costly,and thatthecost is proportional the amount being repudiated.In addition, we assume that individualsknow the relevant model; hence, since thereis no unceron netrateof interest the equilibrium tainty, public bonds (adjusted fordebt repudiation) equals the rate of returnon capital (the cost of private funds).The main opportunity resultof the sectionis thatif an equilibrium with a positivepublic debt exists,thereare in generaltwo equilibrium points: a "good" in whichthereis Pareto-efficient equilibrium and a "bad" Pareto-inno debt repudiation, efficient equilibriumwheredebt is partially repudiated. In Section II we focus on a monetary economy with non-indexedbonds. Obviis equivalent ously, in this contextinflation but negative to some form of repudiation, has to be allowed forsinceprice repudiation deflationcannot be ruled out. In order to cast the example in terms of a standard monetary model, we follow Barro and Gordon (1983a,b) and modifythe previous model by assuming that price changes are thatare costly.This is enoughto giveresults similarto the ones in the nonqualitatively monetary model. Typical of a monetary economy, however, the two equilibria are At the (relatively)good Pareto inefficient.

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inflation and thenominalinterequilibrium, est rate on government bonds are lowerthan In addition, we show at thebad equilibrium. on governthatif insteadthenominalreturn mentbonds were fullyindexed to the price level, then the first-best solution with prewhichsuggests commitment can be attained, that, if inflation is the only means of debt repudiation,indexationof the public debt could lead the economyto a Pareto-superior outcome. In Section III the analysisis extendedto an open economy where foreigners hold a positiveshareof totalpublic debt. The main purpose of thisshortsectionis to establisha linkwiththerelatively theory well-developed We show thatmultiof sovereign borrowing. ple equilibria still can occur in this new context, and that the effecton the bond parinterestrate of increasingforeigners' in thatmarket ticipation dependson whether the economysettlesdown to the good or to the bad equilibrium. Finally, Section IV summarizessome of the centralfindings, and discussessome extensions and suggestionsfor furtherresearch. I. DebtRepudiation Thereare twoperiods:period0 and period 1, and two types of agents: identicalcompetitiveconsumers(or individuals)and the government.In period 0 the government borrowsb per capita unitsof outputwitha factor'Rb, thatis, in period (gross) interest 1 consumerswill receiveRb unitsof output has not hold and which per unitof bond they if consumers exbeingrepudiated. Therefore, 0 of total bonds will pect that a proportion 0 < 0 < 1, the net interest be repudiated, factorwould be2
(1- O)Rb.

We assume consumers can accumulate physical capital witha constantnet interest factor equal to R >1; hence, in a perfect withpositivestocksof equilibrium foresight bonds, consumers capital and government between thesetwotypes shouldbe indifferent of assets,and, consequently (1) (1- 9)Rb= R.

of the government The budget constraint in period 1 is (2) x= (1-O)bRb+g+a9bRb,

whereb, x, and g are theper capita stockof expenditure, bonds, taxes, and government and a standsfortheper capita respectively, debt3(O < a < 1). cost per unit of repudiated Thus, in other words,taxes are requiredto (1- O)bRb,governfinancedebt repayment, g, and the costs of debt ment expenditure, we asrepudiation, aObRb. Furthermore, sume that g is exogenous.4 By (2), (3) ObRb= bRb?g9- X 1

In period 1 individuals consume all of their wealth; thus, assuming that government expendituredoes not directlyaffect in period 1, c, we have privateconsumption (4) c=y-z(x)+kR?(1-O)bRb-xI where y is endowmentincome, z(x) is a the "deadweight"cost function representing
3

ILet r be an interest rate; we definethe corresponding interest factoras (1 + r). Repudiation is a catchall word in this paper that includes anythingfromopen repudiationto a tax on interest.

costs associof as transactions a could be thought (legal fees,etc.,whenrepudiated withdebt repudiation ation is open). In Section IV othertypesof costs are however,that in this discussed. It should be stressed, in examining the "mechanics" paper we are interested associated with these typesof costs as a prelude to a more substantiveanalysis where those costs will be subject to a closer scrutiny. 'In a more realisticmodel, the expectednet return of expectedgovernon capital will also be a function mentpolicy (throughexpectedcapital levies,forexample). The relationshipbetweenthe latterand "capital been exploredby Eaton (1987). flight" has recently

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pudiation,6 = 0; thustaxeshave to be equal to g plus debt repayment. we will asFor the sake of definiteness, z(0) = z'(O) = 0, (5a) sume g> 0 and b> 0, unless otherwise stated; thus,by (5), if Rb> 0 (the only relez"(x)>0 (5b) forallx, vant case for the model of thissection),the minimization of (7) subjectto (8) is attained lim z'(x). (5c) lim z'(x)=xo=at some unique x > 0. Notice that,due to x (8), the solutionwill dependon g, and, most for our discussionhere,it will The last Inada-typeconditionwill simplify importantly of our results. also depend on Rb, the interestfactoron the presentation bonds (which,as argued above, is a prede(3) in (4), we get Employing termined variablein period1). The maximum problem for the govern(6) c=y-z(x)+kR+bRb mentin period 1 is depictedin Figure1.7 In thetwo functions assothe figure we portray -(bRb+g-x)/(1-a)-x. ciated with constraint(8). Given Rb, the is thusconstrained to choose x Consequently,a "benevolent" government government from linesstemming that triesto maximizec in period 1 subject betweenthetwostraight g on the verticalaxis. If x* is located as in (2), and takingRb to its budget constraint, will be able to Figure 1, the government as given (recall that,by assumption,Rb is x*, if Rb maximum negotiatedat time0), will choose x so as to attain theunconstrained lies betweenR and R (see Figure1). On the minimize willbe otherhand, if Rb < RI themaximum attainedon the upperbound (wherethereis z(x)(7) - a x, no repudiation,6 = 0), whileif Rb > R, the maximum lie on the lower bound (where < < 1. In otherwords, repudiation is total, 6 = 1). Consequently, subject to (2), and 0 ? theproblemis to minimize (7) by choosingx the set of best responsesor "reaction funcin period 1, given such that the associated 6 in budget contion" forthe government [0,1]. This condi- Rb, is depicted by the heavyline of broken straint (2) is in theinterval x in the tion is equivalent to restricting segmentsin Figure 1. Notice thatwhen Rb < R the government will be induced to remanner, following pudiate none of its debt (i.e., set 6 = 0), (8) whereas if R ? R repudiationwill be total g+abRb<x<g+bRb. (i.e., 6=1). In between R and R, repudiaexpressionin (8) Notice that the left-most tion will be partial,and-by (2), and recal6 = 1, correspondsto totaldebt repudiation, ling thatin thisregionx = x*- therepudiain whichcase taxes are equal to government tion share, 6, will increasewith Rb; thus,in consumption,g, plus the cost of total re- otherwords, theoptimal sharein repudiation pudiation, abR b. On the other hand, the period 1 is an increasing of theinterfunction to no re- est ratecontracted expressioncorresponds right-most inperiod0. in an equilibrium We will be interested concept in which individualsat time 0 are able to predicttheoptimalgovernment policy in period 1 (i.e., the optimal government
>O x -X

of taxation,5and k is per capita physical capital.6We assume

5Alternatively, one could follow Barro (1979) and assume 7(x) measures tax collectioncosts; under this interpretation, z(x) should be includedin the RHS of (2). 6Thereis no real need to keep trackof thenonnegativity of c, because in thismodelone can alwaysensure thatby setting endowment income,y, sufficiently large.

7I am verygrateful to Elhanan Helpman forsuggesting Figures 1 and 2, whichgreatly improvedthe intuitiveappeal of the presentation.

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x
/(

g+bR
no repudiation )

PARTIALREPUDIATION X 9

full repudiation)

g9+abR

I FUNCTION IN PERIOD1 I

j GOVERNMENT'S REACTION
R

Rb

FIGURE 1. DETERMINATIONOF GOVERNMENT'SREACTION FUNCTION IN PERIOD 1

decision about x and 6 at time 1 as disUnder certainty. cussed above) withperfect (1) holds and, hence,by thesecircumstances (2), (9) x = g + (1-a)bR + abRb.

condition"that The latteris a "consistency budget by thegovernment's mustbe satisfied where,by definiconstraintat equilibrium, tion, the public can predictexactlythe rebepudiation share, 6, and it is indifferent tween holding bonds or capital (i.e., equathat Notice,incidentally, tion(1) is satisfied). (1) impliesthatequasince 6 is nonnegative, overtherangewhere tion(9) is onlyrelevant rate on the interest where that 2 R, is, Rb public bonds exceedsor equals thatof physical capital. and thegoverncondition The consistency are depictedin Figment'sreactionfunction ure 2 for the case in which x* > g + bR. Equilibria are found at points of intersection; in the presentcase these are E0 and on bonds, Rb, factor E. At E? the interest is equal to thaton capital, R, meaningthat the public expects no repudiation;on the optimal reother hand, the government's sponse in period 1 is to set x = g + bR, which,as indicatedin Figures 1 and 2, lies

sectionof its reaction on the no-repudiation function. Expectations are, thus, fulfilled. solutionthe Notice that at this equilibrium would wish to increasex above government g + bR and toward x*, but thatis impossible because it would call for setting6 < 0 whichhas been ruled (negativerepudiation), out by assumption.8 F', repudiation In the otherequilibrium, is partial and, thus, the associated interest than denoted R' in Figure2, is larger factor, the that on capital, R. At this equilibrium, governmentis able to attain the unconstrainedoptimumvalue of x, x*. Our previous discussioncoveredthe case x* < in which x* > g + bR. If, contrariwise, g + bR, the curve depictingthe consistency a pointlike A in conditionwould stemfrom Figure 2; it is easy to see thatthelatterand willnever function reaction thegovernment's

willbe relaxedin SectionII. 8This typeof constraint example However,one simpleway to extendthepresent to allow for 0 < 0 would be to assume that negative repudiationis also costly. It is easy to see that this at would remove any incentivefromthe government time 1 to set 0 < 0, because the latterwould involve bigger tax distortionsand repudiationcosts than if 0 = 0.

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X A

g+bRb g+(1-a)bR+abR

x
g+ bR

F
I
I

t-

I\

GOVERNMENT'S REACTION FUNCTION IN PERIOD 1 CONSISTENCY CONDITION

I
_ _ _

RRb

FIGURE 2. DETERMINATIONOF EQUILIBRIUM

cross,becausetheslopeof theconsistency- thereare no directrepudiation costs,and condition 0 = 1 eliminates curve is equal to that thedeadweight of theright- thatsetting mostsection ofthereaction the debt. function. Conse- cost of taxes required to service quently,there is no equilibrium But,ofcourse, this cannot be an equilibrium with a stock ofbonds. positive In addition with a positive stock ofbonds. to Finally, in theborderline case where x* = thisbasicintuition, ourexample confirming g + bR, equilibrium is unique and R' = R = showsthatthenonexistence could problem R. The following proposition summarizes our arisewitha positive a, and thatthecritical findings: valueforthelatter depends positively on the valueof theoutstanding debt. PROPOSITION 1: If x* > g + bR, then The most important implication of the thereexist two equilibrium solutions;one of analysis, is thatproblems however, do not thesolutions exhibits no repudiation, whilein necessarily go awaywhenrepudiation costs the otherthepublic debtis partially repudia- are setabovethecritical in sucha level;for, ted. On theother hand, ifx* < g + bR, there case theeconomy willnormally exhibit two is no equilibrium, and in theborderline case a nonrepudiation in equilibria: equilibrium that x* = g + bR, equilibrium is uniqueand whichtaxesequal g + bR (recallFigure 2), thereis no repudiation. in which thedebtis and another equilibrium and taxesare set at x* partially repudiated Our modelhas several interesting implica- > g + bR. Notice that,by (1) and (4), in we have tions.In thefirst place,noticethat, by (7), equilibrium x* is an increasing function of thecost of repudiation, a; hence, given theinitial stock of debt,there is somecritical valueforthe (10) c=y-z(x)+(k+b)R-x. cost of repudiation below whichno equilibrium with a positive amountof bonds Therefore,these two solutionscan be wouldexist.The possibility of nonexistence Pareto-ranked, and thenonrepudiation soluofequilibrium is intuitively clearfor thecase tion is the dominant one. Unfortunately, a = 0; for,a benevolent government would however,withoutfurther restrictions the repudiate 100 percent of thedebtgiven that economy could end up at anyone of these

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factorin the "good" equilibria.The interest the value equilibriumis always R; however, (E1 of R,, and 0 at the "bad" equilibrium in Figure 2) are sensitiveto changes in b. as it can easily be Somewhatparadoxically, establishedemployingFigure 2, at the bad equilibriumthebondinterest factoris smaller government the largeris the totaloutstanding that the debt. It should be noted,however, consumptioncost of being at the bad equilibrium is independentof total debt9 (bedoes not depend cause x = x*, and thelatter on b). But, on the otherhand, x* depends our analysis repositivelyon a; therefore, veals that while repudiationcosts are importantfor ensuringthe existenceof equilibria witha positivestockof bonds, by (5), (7), and (10), the largerare the repudiation costs,thelargerwill also be theconsumption cost associated with the bad equilibrium. thecostsof repudiincreasing Thus, although the"credibility" ofthegovernationenhances thelatter maybe mentin thecapitalmarkets, at thecostof lowerconsumption if the bought endsup at thebad equilibrium. economy The way the above "game" has been structuredis consistentwith situationsin at time0 auctionsoff whichthe government the freeto determine b, and lets the market associated interestfactor,R b An alternaat time0 tive10 would be forthegovernment to refuse to sell bonds at interestfactors which are equal to or exceed R',, (recall Figure 2). Thus, under our assumptionsit follows that the only possible equilibrium best. This is an would be Rh,= R, the first importantobservationwhich suggeststhat free auctioningof the public debt may be in whichthegoverndominatedby a system ment stops selling bonds afterthe implied bounds.This ratesgo beyondcertain interest relevance observation will take up further of thenext whenwe discuss it in thecontext section.

II. Money Debt andNon-Indexed takesa The concept of partialrepudiation in thecontext more familiar form of a monetary model, because when variablesare expressed in real terms, changesin the rate of inflation imply changesin the real value of assets which are not indexed to the price level. Two important assets of thiskind are (high-powered) moneyand nominalgovernhas paid a great ment debt. The literature deal of attention to theformer (forexample, Barro and Gordon, 1983a,b); Lucas and Stokey,1983; Calvo (1978a,b), but thereis of growingawarenessabout the importance the role of nominaldebt (for understanding example,HenningBohn 1987; Grossmanand Van Huyck, 1987; Persson, Persson, and Svensson,1987). As faras I know,however, none of the available papers addresses the which of equilibria, issue of non-uniqueness discussion. is the main focusof thefollowing To minimizethe use of new notation, we on factor redefine Rb as thenominalinterest bonds (i.e., Rb =- + i, nominal non-indexed where i is the nominal interestrate from periods 0 to 1). Thus, if we let Pf stand for the price level in period t = 0,1, then the bonds would real interest factoron period-O be
(11)
RbPO/Pl.

We can, therefore, thinkof the ratio PO/Pi as theshareof thedebtwhichis not repudiated in period 1; hence,usingthe notationof previoussection,we will write (12) Po/Pi= (1- O).

periods 0 and 1, T, as follows,

We define the rate of inflation between

p1 - PO
PO

(13)

X=

cussed in Section IV. 1(This fine point was suggestedto me by Assaf Razin.

9This invariance does not hold in the model dis-

Thus, by (12) and (13)

(14) 0=1+

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Consequently,each rate of inflation, r, -1 < , is associated with a unique rate of repudiation,9. We are thusentitled to carry out our discussionin termsof 0 instead of r. Notice, however, thatcontrary to theprevious section,0 could be negative because it is only constrained to satisfy (15) - Do< O <1.

period 1 it would be givenby (17) M P1

= (Ml /P1)-( Mo/Po)(PO/PJ)
= K@,

In line withour previousresults, it is easy to convinceoneselfthatif thecosts of inflaare nil,thena socialwelfare tion/repudiation maximizerwill repudiate100 percentof the debt, that is, he will set 0 = 1-or, equivalently,X = oo. Therefore, the existence of a well-defined interior equilibrium solutionrequires, once again, the introduction of (social) repudiationcosts. As a matterof fact, one could translatethe model of Section II in monetary termsusing (14), and interpret those costs as being relatedto, forexample, the Olivera-Tanzieffect. However,I believe it will be moreusefulto developthe analysis in termsof a more conventional monetary model in whichinflation costs directly affect the consumers' utilityfunctions (see Barro and Gordon, 1983a,b), and where explicit account is taken of the inflationtax on high-powered money. Let the supplyof high-powered moneyin period t, t = 0,1, be denotedby M. For the sake of simplicity, we assumethatthemonetary authoritiescan directlydetermine the price level P, by, for example, settingthe we assume that exchangerate. Furthermore, thedemand formoneysatisfies"

wherethelast equalityfollows from (12) and (16). The governmentbudget constraint in period 1 is givenby (18) x = (1-O)bRb + g-KO.

This is similarto (2) above,exceptthatinflation is assumed not to be costly for the and the inflationtax is subgovernment, tracted from total government expenditure (inclusiveof debt service)in orderto calculate the amount of required conventional taxes. Effective as folconsumption, c, is defined lows, (19) c=y-z(x)+kR+(1-O)bRb
- X
-

KO -(),

where 91(.) is the inflation-cost function. Again, this is verysimilarto (4) above, except thatwe have quite naturally subtracted the inflationtax, and, as discussed at the outset,we assume that inflation is reflected in a directwelfarecost forconsumers. We assume (20a) (20b) 9 (0) = 9J'(0) = 0, 91"(0) > 0 forallO.

(16)

M/P = K,

K> 0

The revenuefrominflation is conventionally definedas the amountof real resources that the government can obtainby the associated sale of high-powered money;thus,in

We will firststudy the optimal problem withprecommitment, thatis, theproblemof maximizingc withrespectto 0 in period 0. Since we maintaintheassumption of perfect foresight, equation (1)-the Fisherequation -holds. Therefore, the above-mentioned problemcan be formally statedas follows: Maxc,
0 <1

IIThe following simpleform is sufficient forconveying the centralinsightsof this section.Extensionsare possible; however, see fn.14.

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subject to (1), (18), and (19).12 The latteris equivalentto (21) Min [z(g + bR-KO)+ 9(O)],
0< I

negotiatedin theprevious period(i.e., period 0), and, by assumption, Rb is not contingent on future policy or events. By (22), at an interior13 (second-best)optimumwe have (23) F
--

which,by (5) and (20) has a unique solution, denoted 6 FB (for "first best"). Since the functionin (21) is strictly convex,one can readily prove the following useful proposition: PROPOSITION 2: Assume that (1) holds, and let c' be theeffective associconsumption ated with9', i=1,2; then,if 1FB<61<62

z'(x)(bRb +

K) + N'(0)

= 0

wehavethat C2

< C1.

wheresignsover thevariablesindicatethose of thecorresponding at an partialderivatives interior solution. Consequently,the (secis an increasing ond-best) rate of inflation functionof nominal debt service,bRb, and government expenditure, g. An important of the above is implication thatif thereexistsa positivestockof government bonds, b, then aSB is an increasing function of the nominalinterest rate factor, (22) Min F(9; Rb) Rb; but, by Fisher equation (1), equilibrium O is also an increasingfunction of Rb and in thus-like 1-the two schedules Figure Min[z(g + b(1- O)Rb - KO)+ 91(6)]. (i.e., the government's reaction function9p and the Fisher equilibrium are relationship) Notice thatin the first-best upward sloping, which, once again, opens problem(21) the government takes(1) intoaccountbecause it the door formultiple equilibria. is maximizing fromtheperspective of period It is importantto notice that in the ab0 and consumerswould not be in an (inter- sence of government debt (i.e., b = 0), equiior) equilibriumif the Fisherequation does libriumwill be unique because 6SB would be not hold. In (22), however, the government independent of Rb. Thus,in thepresent simcontrols 0 taking Rb as given,because it ple context, the familiarinflationtax on maximizeseffective in period 1 role consumption high-powered moneyplaysno significant in an environment in which Rb has been in causingnon-uniqueness.14

In other words, the above proposition states thatif inflation is higher thanits firstbest level, thensocial welfare-as measured by effective consumption- is a decreasing function of inflation. We now turnto the second-best situation which is the focus of our analysis. The is not able to precommitthe government inflationlevel, and, therefore, the government maximizessocial welfarein period 1, takingtheinterest ratefactor Rb and period0 inflationary expectations as given.Recalling (19), thisproblemis equivalentto

implying, by (5) and (20) thatoptimal0 > 0. The second-orderconditionis always satisfied because F is strictly convex with respect to 0. Also, noticethat, by (5) and (20), the minimization problem(22) always has a the solusolution, and by strictconvexity, tionis unique; we denoteit 05B (for"second best"). By (23), thereexists some function p(-,-), such that (24)
B-

(bR b, g )

l2This is like the optimization problemexaminedin Phelps (1973). Its solutiondiffers fromMilton Friedman's OptimumQuantity of Money (9 = 0 in thepresto Friedman, we assume ent context)because, contrary taxes are distorting.

13In what follows we will concentrate on interior solutions (i.e., 9 < 1), corresponding to cases in which the inflation rate is less thaninfinity (recall (14)). 14This resultcould be extendedto the case in which the demand formoneyis sensitive to therateof interest

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In order to completethe non-uniqueness the next step will be to show a argument, when b > simpleexampleof non-uniqueness 0. Consider the case in which

condition for a By (21), the first-order optimumis first-best (28) - z'(g + bR KO)K

+ 9V(O)

= 0.

(25)

3(O) = 902

by (1) and (23), we have Therefore, (26) Z (x) =bRI(I6 )+K

Thus, recallingthatin SectionII we assumed On the g>0 and b>0, we have 0FB>0. other hand, recalling (18), the first-order condition for a second-bestoptimumis at equilibrium-that is, when(1) holds(29) -Z'(g + bR- K6)(bR+ +?N'(6) =0. Notice that,by (5), (20), (28), and (29), the first-andsecond-bestoptima satisfyK0<g one of these + bR, implying thatin neither tax be enough to optima will the inflation Conexpenditures. financetotal government sequently,by (5), (20), (28), and (29), we have, at equilibrium, (30)
6SB>6FB

K)

and, by (1) and (18), we get (27) x=bR+g-KO.

(26) and (27) are Equilibriumrelationships depicted in Figure 3 for the limit case in whichthe demand formoneyis zero,thatis, it is quite clear that X = 0. By continuity, of solutionswould continueto multiplicity of 0. It is, hold forK in some neighborhood to note thatin the veryinteresting however, presentexample uniquenesswould prevailif conK is sufficiently large.'5This is perfectly sistent with our previous observationthat moneyis conthe existenceof high-powered is also highly The result duciveto uniqueness. suggestive;since the value of K may have a of a history lot to do with the inflationary the above resultindicatesthat mulcountry, for problem tiple solutionsmay be a bigger from countrieswhich have recently suffered highinflation.'6

of z'(x) withrespectto x is less than if the elasticity unity,and the inflationtax does not exceed regular however, relieson the taxes,thenormalcase. Our proof, existenceof more than two periods,and will,therefore, model of not be presentedhere. For an infinite-horizon non-uniquenessalong the present lines, but without bonds, see Maurice Obsfeld(1988). government '5The exact condition is K > bR + g, that is, real exmonetarybalances must exceed total government service on penditure,including the inflation-adjusted the public debt. 6This point emergedduringa useful conversation withSwedervan Wijnbergen.

In otherwords,we have shownthatoptimal is lower than with precommitment inflation solutionsobtained in any of the equilibrium reConsequently, under no precommitment. calling Proposition2, we deduce that equican be ranked precommitment libria without rates: accordingto theirassociatedinflation given any two of these equilibria,the one yields the largestrate of inflation exhibiting the smallest social welfare(as measuredby of see (19)). In terms effective consumption, the example associated withFigure3, therefore,we are entitledto call O0 the "good," and 0' the"bad" equilibrium.'7 debt has Price indexationof government on this economysince it importanteffects removes the inflationincentivesassociated indexawiththedebt burden.Withfull-price

17 Multiple equilibria is by no means a necessary feature of these models. Uniqueness would, in fact, (0) = v2; the latteris related prevail if, forexample, 9t to the work of Barro and Gordon (1983a,b) and Bohn (1987). For a somewhat detailed discussion of these issues, see Calvo (1987).

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x
Z'(x)=fl 0 bR-)

g+bR
,,I

b
I

F uI

FIGURE 3. MONETARY EXAMPLE

tion and an interest-insensitive demand for money (i.e., constant K, as in the present model), it is easy to see thatthe no precommitment coincideswiththe first equilibrium best.'8 An alternative to indexation-which was discussed at the end of SectionI-is to put bounds on interest rates; this could ensure that the solution settlesat 60 in Figure 3 ratherthan at 01. However,one can easily show thatsuch a solutionis inferior to bond indexation, because thelatter results in lower 2 and (30)).2? inflation'9 (recall Proposition

18Indexation would not suffice forattaining the firstbest solutionif thedemandformoneyis sensitive to the rate of interest.I conjecture, however,that thereare relevantexamples whereone could stillshow thatdebt indexationincreasessocial welfare. 19This is not intendedto be a thorough analysisof the welfareeconomics of bond indexationsince there are some important aspectsof theissue whichhave not been takeninto account.For example,as pointedout to me by Nissan Liviatan,it has been arguedthatindexation may reduce thebase of theinflation tax because in such a case bonds become better substitutes fordomestic money.This aspect is not coveredby our discussion because K was assumed to be independent of thedegree of indexation. 20 Bounds on interest rates may be particularly difficultto implement when thereexistsan active private capital market. See Calvo (1987) forsome discussionon thisissue.

As theexampledepicted in Figure3 shows, an increase in the cost of inflation (i.e., an increase in /3,recall (25)), has ambiguous results on welfare.A rise in /3 causes the curve in Figure 3 to shiftupward, raising in the bad equilibrium, inflation and lowering it in the good one. Clearly, net consumption, c, will decrease in the bad equilibrium (because /3and inflation go up). In thegood equilibrium (i.e., 60), on the otherhand, the picture is less clear, because inflation goes down, which tends to be welfare improving. However, if K = 0, a simple manipulation using (26) and (27) shows that welfareincreases with /3.Thus, as in Section I, the effects of increasing thecostsof inflation/repudiation are ambiguous: they could be in the good equilibrium, welfare-improving but theydefinitely lowerwelfarein the bad equilibrium. Our example sheds some lighton theissue studied by Bennett McCallum (1984) of whether monetary policycould be separated from fiscalconsiderations. His discussion has to do with the long-run (literally when t -of policies that keep money x) feasibility supply at a constantlevel while runninga fiscal deficit.In our model the relationship betweentherateof inflation and fiscal policy is very direct for the case of non-indexed bonds (still the dominantkind of govern-

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mentbonds in the UnitedStatesand several other countries),and confirms and complementsMcCallum's insight that thereare no grounds for expectingfiscalpolicy to have no monetaryimplications even though,for instance,the monetary authority promises to keep a constant price level (or a constant money supply in a setup wherethe latteris explicitly modeled). In our model this happens because the government may not commit itself crediblyto zero inflation in the presenceof non-indexed debt,sincethelevel of the latter determinesthe set of equilibrium inflationrates that could be susbetween ex post. This relationship tamned the stockof government bonds and inflation, will hold true even when the incidentally, equilibrium is unique(see Bohn,1987). Our resultsadd a pessimistic note to the view that price controlsmighthelp leading theeconomyto the"good" solution,22 which appears to have played some role in the design of the recent"heterodox" stabilization plans in Argentina, Brazil, and Israel. This is so, because in our example the has directcontrolon the price government level, but, once again,non-uniqueness arises due to the fact that its ex post behavioris not immune to ex ante expectations. As a matterof fact,our previousdiscussionsuggests that interest-rate peggingof some sort may be as much a crucial ingredient of a crediblestabilization effort as price controls rate peggingcould in are, and that interest some occasions be all that is needed for credibility. III. International Debt.A Short Detour Borrowingand lending among sovereign states has recently receivedconsiderableattention(see, for instance,the recentsurvey and Stiglitz, by Eaton, Gersovitz, 1986), so a

few words establishingthe connectionbetween the present paper and that type of literature may be in order. A common characteristic of our examples is thatthe "size of thepenalty"(i.e., thecost of repudiation)is a function of thedegreeof repudiation;in theexampleof Section II the cost was proportionalto the value of the debt, whereasin thatof SectionIII the cost was simply a function of the fractionthat was repudiated. In the international debt literature, on the otherhand, it is typically bears assumed that the cost of repudiation no relationship to the size of the debt. This so easy forus explains why it was relatively to generatemultipleequilibriawhile in that literature equilibrium is typically unique.23 The presenceof foreign debt adds an interesting twistto our previousmodels.Thus, for example, we could assume that only a proportiony, 0 < y <1, of the total public while debt is owned by domesticresidents, whosewelfare (1 - y) is owned by foreigners is of no concern to the local authorities. Thus equation (4) now becomes (4') c =y-z(x)+kR + y(l-6 )bRb-x, and (19) is similarly modified. One can now examine the relationship betweeny and the equilibriumoutcomes.This is a straightforward exercise which, however,shows that the results depend very stronglyon the model. In the modelof SectionI, an increase in foreign of thepublic debt (i.e., ownership a fall in y) inducesa fallin thebond interest rate at thebad equilibrium, but no changeat the good one. On the other hand, in the monetarymodel of Section II (with K = 0), interest rates in both equilibriaare affected, and fallingin risingin the bad equilibrium the good one. There does not seem, therebetween fore,to be a clear-cutrelationship in the official the participation of foreigners

Notice thatour arguments establisha linkbetween the stockof non-indexed debt and inflation, in contrast with McCallum (1984) who emphasized the relation betweenfiscaldeficits and inflation. 22For recentmodels thatcould be employedto support thatpoint of view,see Michael Bruno and Fischer (1985) and Miguel Kiguel (1986).

21

An exception is the recentwork of Eaton (1987). where, however,the issue of debt repudiationis not centralto the analysis.

23

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bearingpublic debt (cash, say),whiletherest of society holds high-denomination nonindexed bonds. For the sake of the arguIV. Concluding Remarks ment, suppose, in addition,that everybody pays the same amount of taxes. Clearly,if The centralmessagethatcomes acrossthis the planner adheresto utilitarian principles, paper is thatexpectations mayplay a crucial forexample,debt repudiation could be costly rolein thedetermination of equilibrium when (or beneficial),because the latterwould be the government debt is auctionedoffto the an instrument of wealth redistribution. In public, and thereis no attemptto manage that context,the planner may end up reexpectationsor to peg interest rates on the pudiatingless than 100 percentof the debt government debt. In our examples,we saw (held by the "rich," say) because of the loss thatthenominalinterest rateis not simply a it would cause cash-holders (the "poor"). I passive reflection of people's inflationary exthinkthe analysis of these typesof models but rather pectations, thatthenominalinter- should provideus witha deeperunderstandest rate is actuallyone of the main determi- ing of theseissues. It is myfeeling, however, nants of inflation. Consequently, a credible that the central insightsof this paper will anti-inflationary policywould have to imple- carryoverto thosemodels. mentrules to prevent nominalinterest rates Anotherinteresting extension would be to to become unduly high. The two simple introduceuncertainty. Notice, first, that the mechanismsthat were suggested in our disabove two-periodexamples would not excussion were: (a) price indexation of the hibit random equilibria,because once the public debt, and (b) refraining fromissuing interest rate is determined in period0, there new government bonds when theirinterest exists only one optimumresponse for the rate exceeds some well-defined bounds. In in period 1. An easy extension, government more generalterms, our discussion however,would be to make the repudiation however, pointed out to the advisabilityof govern- cost, a, random.Thus,if individuals are risk mentstakinga moreactivestanceon nomineutral,forexample, Rb timesthe expected nal interest rates.In myopinion,thisimpli- repayment share would in equilibrium equal cation of the formalanalysisis likelyto be the interest factoron capital R; therepudiarelevantin situations particularly wherethe tion shares for each state of nature,on the stabilization program is launched in the otherhand, would depend on Rb (as in our midstof veryhighinflation. previous analysis). Therefore,the equilibThe analysishas been conductedin terms riumvalues of Rb willbe deeplyintertwined of models withone representative distribution consumer withthe probability of a. Clearbecause so muchof therelatedliterature ly, since Rb is just one number,we will has been couched in this form (prominently observe situationswhere ex post the actual Barro, 1979; and Lucas and Stokey 1983). net returnon bonds exceeds (or falls short However,I suspectthatone of theimportant of) that of physical capital. Consequently, reasons for debt repudiationto be costly these models could help explainphenomena (otherthan due to "reputation"costs) is the like the high ex post real interest rates obfact that not all individualsare alike and, served at the beginning of anti-inflationary the incidenceof repudiation therefore, is not programs(see, for instance,Rudiger Dornuniform.24 Consider,for example,a model busch, 1985, and Jeffrey Sachs, 1986). of the type discussed by Thomas Sargent Finally, an importantextension of the and Neil Wallace (1982) whereonly a subanalysis would be to allow for more than set of total population holds non-interest two periods,25 and the simultaneousexistence of explicitrepudiation (for example, interest ratetaxes) and inflation.
24See Carol Rogers (1986) and Calvo and Obstfeld (1988) formodels whichhighlight thelinkbetweentime inconsistency and wealthdistribution. 25For some progresson thisfront, see Calvo (1987).

bonds market, and thedegreeof repudiation or inflation.

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