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Vol. 64, No. 2, pp. 147-159 (2013)

“Impact of Deflation on Real Interest Rate of Government Bonds”
Kazumasa Oguro (Department of Economics, Hosei University), Motohiro Sato (Graduate School of Economics, Hitotsubashi University)

This paper analyzes how deflation and inflation influence the real interest rates of government bonds by using an overlapping generations model. We find that deflation may lower the real interest rate of government bonds to the same level of public debt to capital, even if the fiscal consolidation rule is the same, as opposed to the conventional view that the real interest rate of government bonds is determined independent of deflation if the classical dichotomy holds. Our results are consistent with how the real interest rates of Japanese government bonds react in periods of deflation. This paper also addresses the impact of fiscal inflation (i.e., monetizing all parts of the GB's default using monetary policy). We calculate the expected fiscal inflation when the default rate in the event of fiscal consolidation is raised. The fiscal inflation may be high if the extent of the required tax increase in fiscal consolidation is low.