R. Anton Braun and Tomoyuki Nakajima
Working Paper 2011-13
November 2011

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We compare the dynamics of inflation and bond yields leading up to a sovereign debt crisis in settings where asset markets are frictionless to other settings with financial frictions. As compared with the case with frictionless asset markets, an asset market structure with financial frictions generates a significant delay in the response of prices to news about a future debt crisis. With complete markets, prices jump in response to news about the possibility of a future debt crisis. However, when short selling of government bonds is restricted, some agents can't act on their beliefs, and prices don't respond to the news. Instead, prices only move in periods immediately prior the crisis.

JEL classification: E31, E62, H60

Key words: sovereign debt crisis, deflation, fiscal risk, leverage, borrowing constraint

For helpful comments and suggestions, the authors thank Kosuke Aoki, Fumio Hayashi, Atsushi Kajii, Keiichiro Kobayashi, Masao Ogaki, Kozo Ueda, and seminar participants at the Bank of Japan, CIGS, Federal Reserve Bank of Atlanta, Hitotsubashi University (ICS), Kyoto University, and the University of Tokyo. Part of this research was conducted while Nakajima was a visiting scholar at the Institute for Monetary and Economic Studies at the Bank of Japan, whose hospitality is gratefully acknowledged. Nakajima thanks the financial support from the JSPS. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to R. Anton Braun, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8708, r.anton.braun@gmail.com, or Tomoyuki Nakajima, Institute of Economic Research, Kyoto University and the Canon Institute for Global Studies, Yoshida-Honmachi, Sakyo-ku, Kyoto 606-8501, 81-75-753-7102, nakajima@kier.kyoto-u.ac.jp.

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