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Gambling for redemption and self-fulfilling debt crises

  • Juan Carlos Conesa
  • Timothy J. Kehoe

We develop a model for analyzing the sovereign debt crises of 2010–2012 in the Eurozone. The government sets its expenditure-debt policy optimally. The need to sell large quantities of bonds every period leaves the government vulnerable to self-fulfilling crises in which investors, anticipating a crisis, are unwilling to buy the bonds, thereby provoking the crisis. In this situation, the optimal policy of the government is to reduce its debt to a level where crises are not possible. If, however, the economy is in a recession where there is a positive probability of recovery in fiscal revenues, the government may optimally choose to “gamble for redemption,” running deficits and increasing its debt, thereby increasing its vulnerability to crises.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 465.

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Date of creation: 2012
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Handle: RePEc:fip:fedmsr:465
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  1. S. Rao Aiyagari, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, Oxford University Press, vol. 109(3), pages 659-684.
  2. Fernando A. Broner & Guido Lorenzoni & Sergio L. Schmukler, 2007. "Why Do Emerging Economies Borrow Short Term?," NBER Working Papers 13076, National Bureau of Economic Research, Inc.
  3. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates and the current account," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  4. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany.
  5. Guido Lorenzoni & Ivan Werning, 2013. "Slow Moving Debt Crises," NBER Working Papers 19228, National Bureau of Economic Research, Inc.
  6. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "Varieties of Crises and Their Dates
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    ," Introductory Chapters, Princeton University Press.
  7. Leonardo Martinez & Juan Carlos Hatchondo & Cesar Sosa Padilla, 2011. "Debt Dilution and Sovereign Default Risk," IMF Working Papers 11/70, International Monetary Fund.
  8. Cesar Sosa-Padilla, 2014. "Sovereign Defaults and Banking Crises," 2014 Meeting Papers 666, Society for Economic Dynamics.
  9. Chamley Christophe P & Pinto Brian, 2011. "Why Official Bailouts Tend Not To Work: An Example Motivated by Greece 2010," The Economists' Voice, De Gruyter, vol. 8(1), pages 1-5, February.
  10. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
  11. Cole, Harold L. & Kehoe, Timothy J., 1996. "A self-fulfilling model of Mexico's 1994-1995 debt crisis," Journal of International Economics, Elsevier, vol. 41(3-4), pages 309-330, November.
  12. Harold L. Cole & Timothy J. Kehoe, 1998. "Self-fulfilling debt crises," Staff Report 211, Federal Reserve Bank of Minneapolis.
  13. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
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