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Financial Crisis in Emerging Markets and the Optimal Bailout Policy

Author

Listed:
  • 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.

Suggested Citation

  • Bems, Rudolfs & Jönsson, Kristian, 2002. "Financial Crisis in Emerging Markets and the Optimal Bailout Policy," SSE/EFI Working Paper Series in Economics and Finance 520, Stockholm School of Economics, revised 08 Oct 2004.
  • Handle: RePEc:hhs:hastef:0520
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    References listed on IDEAS

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    More about this item

    Keywords

    financial crisis; government bailout; emerging markets;

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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