Sovereign Default and the Sustainability Risk Premium Effect

Michael Akemann and Fabio Kanczuk write about the joint determination of interest rate risk and debt sustainability for governments with fiscal imbalances. Because higher interest rates imply increased debt services, they worsen the government’s financial situation and increase the probability of sovereign default. Thus, higher interest rates eventually lead to a decrease in the real demand for government bonds, which imposes an additional constraint on government debt sustainability.

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