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Self-Fulfilling Debt Crises

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  • Cole, Harold L
  • Kehoe, Timothy J

Abstract

We characterize the values of government debt and the debt's maturity structure under which financial crises brought on by a loss of confidence in the government can arise within a dynamic, stochastic general equilibrium model. We also characterize the optimal policy response of the government to the threat of such a crisis. We show that when the country's fundamentals place it inside the crisis zone, the government may be motivated to reduce its debt and exit the crisis zone because this leads to an economic boom and a reduction in the interest rate on the government's debt. We show that this reduction can be gradual if debt is high or the probability of a crisis is low. We also show that, while lengthening the maturity of the debt can shrink the crisis zone, credibility-inducing policies can have perverse effects. Copyright 2000 by The Review of Economic Studies Limited

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Bibliographic Info

Article provided by Wiley Blackwell in its journal Review of Economic Studies.

Volume (Year): 67 (2000)
Issue (Month): 1 (January)
Pages: 91-116

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Handle: RePEc:bla:restud:v:67:y:2000:i:1:p:91-116

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  1. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, January.
  2. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  3. Sachs, Jeffrey & Tornell, Aaron & Velasco, Andres, 1996. "The Mexican peso crisis: Sudden death or death foretold?," Journal of International Economics, Elsevier, vol. 41(3-4), pages 265-283, November.
  4. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October.
  5. Alesina, A. & Prati, A. & Tabellini, G., 1989. "Public Confidence And Debt Management: A Model And A Case Study Of Italy," Papers 5, California Los Angeles - Applied Econometrics.
  6. Enrica Detragiache, 1996. "Rational Liquidity Crises in the Sovereign Debt Market: In Search of a Theory," IMF Working Papers 96/38, International Monetary Fund.
  7. Chari, V V & Kehoe, Patrick J, 1993. "Sustainable Plans and Mutual Default," Review of Economic Studies, Wiley Blackwell, vol. 60(1), pages 175-95, January.
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