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Debt Stabilization Games in the Presence of Risk Premia


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  • Engwerda, J.C.
  • Aarle, B. van
  • Plasmans, J.E.J.
  • Weeren, A.J.T.M.

    (Tilburg University, Center for Economic Research)


Abstract: As a result of the recent financial crisis and the ensuing economic recession, fiscal deficits have soared in many OECD countries. As a consequence, government debt has been on the rise again after a period of stable or declining government debt. In this paper we analyze debt stabilization in a country that features endogenous risk premia, imposed by financial markets that evaluate the probability of debt default by governments. Endogenous risk premia arise by assuming e.g. simple linear relations between risk premia and the level of debt. As a result the real interest rate on government debt can be written as a constant (measuring the risk-free real interest rate corrected for real output growth) plus an endogenous risk premium that depends on the debt level. We bring such endogenous risk premia into the Tabellini (1986) model [22] and analyze the impact of it. This gives rise to a nonlinear differential game. We solve this game for both a cooperative setting and a non-cooperative setting. The non-cooperative game is solved under an open-loop information structure. In particular we present a bifurcation analysis w.r.t. the risk premium parameter.

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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2012-056.

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Date of creation: 2012
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Handle: RePEc:dgr:kubcen:2012056

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Keywords: debt stabilization; differential games; nonlinear dynamical systems; economic dynamics;

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  1. Dmitri Blueschke & Reinhard Neck, 2011. "“Core” and “Periphery” in a Monetary Union: A Macroeconomic Policy Game," International Advances in Economic Research, Springer, vol. 17(3), pages 334-346, August.
  2. Engwerda, Jacob C., 1998. "On the open-loop Nash equilibrium in LQ-games," Journal of Economic Dynamics and Control, Elsevier, vol. 22(5), pages 729-762, May.
  3. Caputo, Michael R., 2007. "The envelope theorem for locally differentiable Nash equilibria of finite horizon differential games," Games and Economic Behavior, Elsevier, vol. 61(2), pages 198-224, November.
  4. De Grauwe, Paul & Ji, Yuemei, 2012. "Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone," CEPS Papers 6548, Centre for European Policy Studies.
  5. Weeren, A.J.T.M. & Schumacher, J.M. & Engwerda, J.C., 1994. "Asymptotic analysis of Nash equilibria in nonzero-sum linear-quadratic differential games: The two player case," Research Memorandum 634, Tilburg University, Faculty of Economics and Business Administration.
  6. van den Broek, W. A., 2002. "Moving horizon control in dynamic games," Journal of Economic Dynamics and Control, Elsevier, vol. 26(6), pages 937-961, June.
  7. Reddy, P.V., 2011. "Essays on dynamic games," Open Access publications from Tilburg University urn:nbn:nl:ui:12-5067553, Tilburg University.
  8. Bovenberg, A.L. & Aarle, B. van & Raith, M., 1997. "Is there a tragedy of a common Central Bank? A dynamic analysis," Open Access publications from Tilburg University urn:nbn:nl:ui:12-74435, Tilburg University.
  9. Tabellini, Guido, 1986. "Money, debt and deficits in a dynamic game," Journal of Economic Dynamics and Control, Elsevier, vol. 10(4), pages 427-442, December.
  10. Jasper Lukkezen & Hugo Rojas-Romagosa, 2012. "When is debt sustainable?," CPB Discussion Paper 212, CPB Netherlands Bureau for Economic Policy Analysis.
  11. Reddy, P.V. & Engwerda, J.C., 2011. "Necessary and Sufficient Conditions for Pareto Optimality in Infinite Horizon Cooperative Differential Games," Discussion Paper 2011-041, Tilburg University, Center for Economic Research.
  12. Giovanni Di Bartolomeo & Debora Di Gioacchino, 2008. "Fiscal-monetary policy coordination and debt management: a two-stage analysis," Empirica, Springer, vol. 35(4), pages 433-448, September.
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