DEFAULT RISK PREMIA ON GOVERNMENT BONDS IN A QUANTITATIVE MACROECONOMIC MODEL

In: Juessen, Falko, Linnemann, Ludger and Schabert, Andreas (2016). DEFAULT RISK PREMIA ON GOVERNMENT BONDS IN A QUANTITATIVE MACROECONOMIC MODEL. Macroecon. Dyn., 20 (1). S. 380 - 404. NEW YORK: CAMBRIDGE UNIV PRESS. ISSN 1469-8056

Open Access

Abstract

We develop a macroeconomic model in which the government does not guarantee to repay debt. We ask whether movements in the price of government bonds can be rationalized by lenders' unwillingness to fully roll over debt when the outstanding level of debt exceeds the government's repayment capacity. Investors do not support a Ponzi game in this case, but ration credit supply, thus forcing default at an endogenously determined fractional repayment rate. Interest rates on government bonds reflect expectations of this event. Numerical results show that default premia can emerge at moderately high debt-to-GDP ratios where even small changes in fundamentals lead to steeply rising interest rates. The behavior of risk premia broadly accords with recent observations for several European countries that experienced a worsening of fundamental fiscal conditions.