Abstract
Episodes of high inflation are generally accompanied by a shortening of the maturity of nominal debt contracts. This paper develops a multiperiod general equilibrium model with incomplete markets to study the relationship between inflation and the maturity structure of nominal bonds. Agents can trade with nominal and real bonds of all maturities. The model shows that under the presence of a small risk of price stabilization, high inflation can lead to a significant shortening of the maturities of nominal bonds traded among agents; it yields a negative relationship between the level of inflation and the average maturity of the traded nominal bonds. It is the interaction of the possibility that ex-post real interest rates on the long term nominal bonds will be very large with the fact that this possibility is very small that leads the borrowers to avoid these contracts when there is a no default constraint. A high variance of inflation alone is not sufficient to induce a shortening of the maturity of traded nominal bonds. This paper brings strong evidence that supports the model’s predictions using data from Treasury auctions in Turkey between 1986 and 2003. Governments in the emerging markets often issue local-currency debt at short maturities and rely instead on bonds denominated in foreign currency to borrow at long maturities. The model in this paper offers a potential explanation for this phenomenon known as the “Original Sin”.
Source: Treasury auction data from Turkey between 1986 and 2003. Note that "maturity" is computed as the monthly
weighted average of the maturities.