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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 is 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 may be quite 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.

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Bibliographic Info

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. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, December.
  2. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans and mutual default," Staff Report 124, Federal Reserve Bank of Minneapolis.
  3. 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.
  4. Alberto Alesina & Alessandro Prati & Guido Tabellini, 1989. "Public Confidence and Debt Management: A Model and A Case Study of Italy," NBER Working Papers 3135, National Bureau of Economic Research, Inc.
  5. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October.
  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. Enrica Detragiache, 1996. "Rational Liquidity Crises in the Sovereign Debt Market," IMF Working Papers 96/38, International Monetary Fund.
  8. 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.
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