This paper is an analysis of the simultaneous determination of financial default and political crises and its consequences. It focuses on a small open economy that faces a debt default decision. Crucially, this decision is made by a government that has superior information than the public about the social costs of default. Citizens can dismiss the government, and overrule its default decision, at the cost of a political crisis. If there is a divergence between the objectives of the government and its people, a political crisis may emerge in equilibrium. For this to be the case, the foreign debt must be large enough, and international reserves low. When this political equilibrium is seen as a part of a larger investment problem, there are equilibria in which crises are "only financial," and equilibria in which both default and political crises occur. In some cases, these two kinds of equilibria coexist and, in this sense, a loss of confidence by foreign lenders can exacerbate the likelihood of a political crisis. If so, international intervention in financial markets may ensure financial and political stability at little cost.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
11779.
Length: Date of creation: Nov 2005 Date of revision: Handle: RePEc:nbr:nberwo:11779
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Find related papers by JEL classification: F34 - International Economics - - International Finance - - - International Lending and Debt Problems D72 - Microeconomics - - Analysis of Collective Decision-Making - - - Models of Political Processes: Rent-seeking, Elections, Legislatures, and Voting Behavior
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