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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)

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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Bibliographic 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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Keywords: financial crisis; government bailout; emerging markets;

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References

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  1. Dani Rodrik & Andres Velasco, 1999. "Short-Term Capital Flows," NBER Working Papers 7364, National Bureau of Economic Research, Inc.
  2. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sergio, 1999. "Prospective deficits and the asian currency crisis," Policy Research Working Paper Series 2174, The World Bank.
  3. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2001. "A Corporate Balance Sheet Approach to Currency Crises," CEPR Discussion Papers 3092, C.E.P.R. Discussion Papers.
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  14. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
  15. Giancarlo Corsetti & Paolo Pesenti & Nouriel Roubini, 1998. "What Caused the Asian Currency and Financial Crisis?," Temi di discussione (Economic working papers) 343, Bank of Italy, Economic Research and International Relations Area.
  16. Arnott, Richard J & Stiglitz, Joseph E, 1988. " The Basic Analytics of Moral Hazard," Scandinavian Journal of Economics, Wiley Blackwell, vol. 90(3), pages 383-413.
  17. Allen, Franklin & Gale, Douglas, 2000. "Optimal currency crises," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 53(1), pages 177-230, December.
  18. 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.
  19. Roberto Chang, 1999. "Understanding recent crises in emerging markets," Economic Review, Federal Reserve Bank of Atlanta, issue Q2, pages 6-16.
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