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High Public Debt in Currency Crises: Fundamentals versus Signalling 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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2862.

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Date of creation: Jul 2001
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Handle: RePEc:cpr:ceprdp:2862
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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. Velasco, Andres, 1996. "Fixed exchange rates: Credibility, flexibility and multiplicity," European Economic Review, Elsevier, vol. 40(3-5), pages 1023-1035, April.
  3. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
  4. Obstfeld, Maurice, 1991. "Destabilizing Effects of Exchange-Rate Escape Clauses," CEPR Discussion Papers 518, C.E.P.R. Discussion Papers.
  5. 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.
  6. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
  7. David Backus & John Driffill, 1984. "Inflation and Reputation," Working Papers 560, Queen's University, Department of Economics.
  8. Rose, A.K. & Svensson, L.E.O., 1993. "European Exchange Rate Credibility Before the Fall," Papers 542, Stockholm - International Economic Studies.
  9. Alessandro Prati & Francesco Drudi, 1999. "Signaling Fiscal Regime Sustainability," IMF Working Papers 99/86, International Monetary Fund.
  10. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
  11. 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.
  12. Sachs, J. & Tornell, A. & Velasco, A., 1996. "The Mexican Peso Crisis: Sudden Death or Death Foretold?," Working Papers 96-20, C.V. Starr Center for Applied Economics, New York University.
  13. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
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