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High public debt in currency crises: fundamentals versus signaling effects

  • Benigno, Pierpaolo
  • Missale, Alessandro

This Paper examines how public debt, government credibility and external circumstances affect the probability of exchange rate devaluations in a three-period open-economy version of the Barro-Gordon (1983) model with nominal public debt. Public debt creates a link between current and future policy actions: resisting a crisis may enhance or undermine the sustainability of the exchange-rate regime depending on whether the government's reputation or fundamentals – i.e. the level of public debt – are critical for sustainability. The focus is on the impact of public debt, debt maturity and government credibility on the expected devaluation for the current and future periods. This allows us to identify factors affecting the short-term interest rate and the forward rate and hence to derive predictions on the level and the slope of the term structure of interest rates.

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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 23 (2004)
Issue (Month): 2 (March)
Pages: 165-188

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Handle: RePEc:eee:jimfin:v:23:y:2004:i:2:p:165-188
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

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  1. Drazen, Allan & Masson, Paul R, 1994. "Credibility of Policies versus Credibility of Policymakers," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 735-54, August.
  2. Drudi, F. & Prati, A., 1998. "Signaling Fiscal Regime Sustainability," Papers 335, Banca Italia - Servizio di Studi.
  3. Maurice Obstfeld, 1995. "Models of Currency Crises with Self-Fulfilling Features," NBER Working Papers 5285, National Bureau of Economic Research, Inc.
  4. Obstfeld, Maurice, 1996. "Destabilizing Effects of Exchange-Rate Escape Clauses," Department of Economics, Working Paper Series qt15n3p5dt, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  5. Backus, David & Driffill, John, 1985. "Inflation and Reputation," American Economic Review, American Economic Association, vol. 75(3), pages 530-38, June.
  6. Sachs, Jeffrey & Tornell, Aaron & Velasco, Andres, 1996. "The Mexican peso crisis: Sudden death or death foretold?," Journal of International Economics, Elsevier, vol. 41(3-4), pages 265-283, November.
  7. Backus, David & Driffill, John, 1985. "Rational Expectations and Policy Credibility Following a Change in Regime," Review of Economic Studies, Wiley Blackwell, vol. 52(2), pages 211-21, April.
  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.
  9. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  10. Rose, Andrew K & Svensson, Lars E O, 1993. "European Exchange Rate Credibility Before the Fall," CEPR Discussion Papers 852, C.E.P.R. Discussion Papers.
  11. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  12. Velasco, Andres, 1996. "Fixed exchange rates: Credibility, flexibility and multiplicity," European Economic Review, Elsevier, vol. 40(3-5), pages 1023-1035, April.
  13. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
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