Stochastic Seigniorage and Sustainable Debt in the Economy of Transition

Stochastic seigniorage, government debt and borrowing dynamics are modeled in the context of a transition economy. Rational investors assessing market risks, hedge against them and construct riskless portfolios of seigniorage and debts. Risk-neutral asset valuation made it possible to formulate equilibrium conditions for the debt sustainability. Lending to the government is considered as a perpetual American call option that is optimized with respect to seigniorage without defaulting on the debt outstanding. The model is applied to the August 1998 domestic debt default in Russia to determine short-run effects of seigniorage upon the government debt sustainability.