Government Debts Under Volatile Price Changes: Simulation Analysis of Japanese Government Bonds

Abstract

This paper is intended as an investigation of the trend of real central government debts, considering the relationship between inflation rates and fiscal sustainability. Hyper-inflation would decrease the real government debts drastically, but if it is not the case then price stability is an important element for fiscal sustainability.

This paper argues that a government cannot use inflation as a method to reduce the real burden of debts. This result comes from the theoretical reasoning that variability of price changes brings higher nominal interest rates by adding a risk premium to them under uncertain fiscal conditions. We discuss that if nominal interest rates have more than one-for-one effects on the expected inflation rate then high inflation rather increases real debts. Such effects are especially important in Japan where most government debts are issued in fixed nominal terms. This paper also shows asymmetric effects of deflation and inflation on real government debts. In a deflationary economy, nominal interest rates have a zero bound so that real interest rates would be higher with deflation.

We also show the fiscal condition quantitatively for cases of Japan’s central government debts, using simulation methods. The recent trend of government debts since 2002 is equivalent to the case of about 1.0% to 1.5% deflation, with 15 trillion yen primary deficits on average. As for the future trend, a primary surplus of about 14 to 25 trillion yen per year would be required to sustain the current level of the debt to GDP ratio for 20 years. −1% and 2% of price changes have almost the same effect on real debts, and 0% inflation would minimize them.