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Financial Crisis in Emerging Markets and the Optimal Bailout Policy

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Author Info
Bems, Rudolfs () (Dept. of Economics, Stockholm School of Economics)
Jönsson, Kristian () (Dept. of Economics, Stockholm School of Economics)

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Abstract

This paper develops a framework for analyzing optimal government bailout policy in a dynamic stochastic general equilibrium model where financial crises are exogenous. Important elements of the model are that private borrowers only internalize part of the social cost of foreign borrowing in the emerging market and that the private sector is illiquid in the event of a crisis. The distinguishing feature of our paper is that it addresses the optimal bailout policy in an environment where there are both costs and benefits of bailouts, and where bailout guarantees potentially distort investment decisions in the private sector. We show that it is always optimal to commit to a bailout policy that only partially protects investment against inefficient liquidation, both in a centralized economy and a market economy. Due to overinvestment in the market economy, the government’s optimal level of bailout guarantees is lower than in the social optimum. Further, we show that, in contrast to a social planner, the government in the market economy should optimally bail out a smaller fraction of private investments when the probability of a crisis increases.

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Publisher Info
Paper provided by Stockholm School of Economics in its series Working Paper Series in Economics and Finance with number 520.

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Length: 40 pages
Date of creation: 20 May 2002
Date of revision: 31 Oct 2003
Handle: RePEc:hhs:hastef:0520

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Related research
Keywords: financial crisis; government bailout; emerging markets;

Find related papers by JEL classification:
F34 - International Economics - - International Finance - - - International Lending and Debt Problems
F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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References listed on IDEAS
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    Other versions:
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  7. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June. [Downloadable!] (restricted)
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  8. Arnott, Richard J & Stiglitz, Joseph E, 1988. " The Basic Analytics of Moral Hazard," Scandinavian Journal of Economics, Blackwell Publishing, vol. 90(3), pages 383-413.
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  9. Roberto Chang, 1999. "Understanding recent crises in emerging markets," Economic Review, Federal Reserve Bank of Atlanta, issue Q2, pages 6-16. [Downloadable!]
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  12. Franklin Allen & Douglas Gale, 2000. "Optimal Currency Crises," Center for Financial Institutions Working Papers 00-23, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
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  13. Douglas Gale & Xavier Vives, 2002. "Dollarization, Bailouts, And The Stability Of The Banking System," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 467-502, May. [Downloadable!] (restricted)
    Other versions:
  14. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1998. "Prospective deficits and the Asian currency crisis," Working Paper Series WP-98-5, Federal Reserve Bank of Chicago. [Downloadable!]
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  15. Cole, Harold L & Kehoe, Timothy J, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Blackwell Publishing, vol. 67(1), pages 91-116, January.
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  16. Xavier Freixas, 1999. "Optimal Bail Out Policy, Conditionality and Constructive Ambiguity," Economics Working Papers 400, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
  17. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sergio, 2004. "Government guarantees and self-fulfilling speculative attacks," Journal of Economic Theory, Elsevier, vol. 119(1), pages 31-63, November. [Downloadable!] (restricted)
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    Other versions:
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