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Default Risk Premia on Government Bonds in a Quantitative Macroeconomic Model

Falko Juessen, Ludger Linnemann and Andreas Schabert
University of Cologne, Working Paper Series in Economics No. 73, 2014

Keywords: Sovereign default; fiscal policy; government debt

We develop a macroeconomic model where 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 and ration credit supply in this case, thus forcing default at an endogenously determined fractional repayment rate. Interest rates on government bonds re.ect 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 to recent observations for several European countries that experienced a worsening of fundamental fiscal conditions.

Default Risk Premia on Government Bonds in a Quantitative Macroeconomic Model