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Optimal bailout during currency and financial crises: A sequential game analysis

  • Mundaca, Gabriela


    (Dept. of Economics, University of Oslo)

We present a model that illustrates the close relationship between the possibility of a currency crisis and the amount of private-sector debt within a four-stage sequential game framework. In the first stage, the government announces its exchange rate policy, and all agents in the economy receive probabilistic information about a future shock that will occur in the last stage. This shock will affect unemployment and net returns on private sector investment. The private sector in stage 2 forms expectations about the future exchange rate and engages in risky investments. In stage 3, the government faces costs due to expectations of future devaluation and private-sector debt, anticipating the stochastic shock that will occur in stage 4 and may or may not find it optimal to pre-emptively abandon its fixed exchange rate policy. The government can commit already in stage 1 to bailing out part of the private sector's outstanding debt if a bad shock occurs or wait until stage 4 to give an optimal bailout. A commitment to bailing out provides a reconciliation of the multiple equilibria that result from self-fulfilling expectations. Moreover, the government may sometimes avert currency crises by committing to bailing out.

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Paper provided by Oslo University, Department of Economics in its series Memorandum with number 27/2002.

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Length: 43 pages
Date of creation: 18 Jun 2003
Date of revision:
Handle: RePEc:hhs:osloec:2002_027
Contact details of provider: Postal: Department of Economics, University of Oslo, P.O Box 1095 Blindern, N-0317 Oslo, Norway
Phone: 22 85 51 27
Fax: 22 85 50 35
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  9. Bordo, Michael D. & Schwartz, Anna J., 2000. "Measuring real economic effects of bailouts: historical perspectives on how countries in financial distress have fared with and without bailouts," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 53(1), pages 81-167, December.
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