IMF Working Papers

Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds

By Matías Moretti, Lorenzo Pandolfi, German Villegas Bauer, Sergio L. Schmukler, Tomás Williams

November 1, 2024

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Format: Chicago

Matías Moretti, Lorenzo Pandolfi, German Villegas Bauer, Sergio L. Schmukler, and Tomás Williams. "Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds", IMF Working Papers 2024, 227 (2024), accessed November 21, 2024, https://doi.org/10.5089/9798400290411.001

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

We present evidence of inelastic demand for risky sovereign bonds and explore its implications for optimal government debt policies. Using monthly changes in the composition of a major international bond index, we identify flow shocks unrelated to fundamentals that shift the available bond supply. From these shocks, we estimate an inverse demand elasticity of -0.30 and show that it increases with countries’ default risk. We formulate a sovereign debt model with endogenous default and inelastic investors, calibrated to our empirical estimates. By penalizing additional borrowing, an inelastic demand acts as a disciplining device that reduces default risk and bond spreads.

Keywords: Inelastic financial markets, Institutional investors, International capital markets, Sovereign debt

Publication Details