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Self-Fulfilling Debt Crises

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  • Harold L. Cole
  • Timothy J. Kehoe

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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Paper provided by David K. Levine in its series Levine's Working Paper Archive with number 114.

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Date of creation: 27 Feb 1998
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Handle: RePEc:cla:levarc:114

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  1. Enrica Detragiache, 1996. "Rational Liquidity Crises in the Sovereign Debt Market: In Search of a Theory," IMF Staff Papers, Palgrave Macmillan, vol. 43(3), pages 545-570, September.
  2. Alesina, Alberto F & Prati, Alessandro & Tabellini, Guido, 1989. "Public Confidence and Debt Management: A Model and a Case Study of Italy," CEPR Discussion Papers 351, C.E.P.R. Discussion Papers.
  3. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans," Staff Report 122, Federal Reserve Bank of Minneapolis.
  4. Calvo, Guillermo A & Guidotti, Pablo E, 1992. "Optimal Maturity of Nominal Government Debt: An Infinite-Horizon Model," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 33(4), pages 895-919, November.
  5. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans and mutual default," Staff Report 124, Federal Reserve Bank of Minneapolis.
  6. Jeffrey Sachs & Aaron Tornell & Andres Velasco, 1996. "The Mexican Peso Crisis: Sudden Death or Death Foretold?," NBER Working Papers 5563, National Bureau of Economic Research, Inc.
  7. Cole, Harold L. & Kehoe, Timothy J., 1996. "A self-fulfilling model of Mexico's 1994-1995 debt crisis," Journal of International Economics, Elsevier, vol. 41(3-4), pages 309-330, November.
  8. Missale, Alessandro & Blanchard, Olivier Jean, 1994. "The Debt Burden and Debt Maturity," American Economic Review, American Economic Association, vol. 84(1), pages 309-19, March.
  9. Enrica Detragiache, 1996. "Rational Liquidity Crises in the Sovereign Debt Market," IMF Working Papers 96/38, International Monetary Fund.
  10. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October.
  11. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
  12. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  13. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
  14. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, December.
  15. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
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