Finance and Economics Discussion Series (FEDS)
A Monetary-Fiscal Theory of Sudden Inflations and Currency Crises
Treating nominal government bonds like other bonds leads to a new theory of sudden inflations and currency crises. Holmstrom (2015) and Gorton (2017) describe bonds as having costly-to-investigate opaque backing that consumers believe is sufficient for repayment. Government bonds' nominal return is their face value, their real return is determined by the government's surplus. In normal times, consumers are confident of repayment but ignorant of the true surpluses that will fund that repayment. When consumers' belief in real repayment wavers, they investigate surpluses. If consumers learn surpluses will be insufficient to repay bonds in real terms, the price level jumps. This explains why we observe inflationary crises, but never deflationary.
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Keywords: Currency Crises, Price Level Determination, Monetary Fiscal Interaction, Fiscal Theory of the Price Level
PDF: Full Paper
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