Public debt and inflation: The role of inflation-sensitive instruments

Abstract

This paper examines the effect of inflation on the choice of government debt structure. We develop work by Missale and Blanchard (American Economic Review, Vol. 84 (1994), No. 1, pp. 309-319) to allow for the joint determination of inflation and the share of inflation-sensitive securities. We assume that governments prefer domestic nominal long-term debt. We show that the subgame perfect equilibrium involves a negative relation between inflationary expectations and the share of such debt. Panel data estimation for 15 OECD countries provides strong support for the theory. © Blackwell Publishers Ltd and The Victoria University of Manchester, 2001. Published by Blackwell Publishers Ltd,.