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

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  • Mundaca, Gabriela

    () (Dept. of Economics, University of Oslo)

Abstract

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.

Suggested Citation

  • Mundaca, Gabriela, 2003. "Optimal bailout during currency and financial crises: A sequential game analysis," Memorandum 27/2002, Oslo University, Department of Economics.
  • Handle: RePEc:hhs:osloec:2002_027
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    File URL: http://www.sv.uio.no/econ/english/research/unpublished-works/working-papers/pdf-files/2002/Memo-27-2002.pdf
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    References listed on IDEAS

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    Cited by:

    1. 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.

    More about this item

    Keywords

    currency crisis; private-sector debt; sequential game analysis; financial crises;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F30 - International Economics - - International Finance - - - General
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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