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Date Published:May 13, 2005
There are different arguments in favor and against nominal and indexed debt which broadly include the incentive to default through inflation versus hedging against unforeseen shocks. We model and calibrate these arguments to assess their quantitative importance. We use a dynamic equilibrium model with tax distortion, government outlays uncertainty, and contingent–debt service, which we take to mean nominal debt. In the model, the benefits of defaulting through inflation are tempered by higher future interest rates. We obtain that calibrated costs from inflation more than offset the benefits from hedging. We further discuss sustainability of nominal debt in developing (volatile) countries.