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

Listed author(s):
  • 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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File URL: http://www.sv.uio.no/econ/english/research/unpublished-works/working-papers/pdf-files/2002/Memo-27-2002.pdf
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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
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
Web page: http://www.oekonomi.uio.no/indexe.html
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  1. Morris, Stephen & Shin, Hyun Song, 1998. "Unique Equilibrium in a Model of Self-Fulfilling Currency Attacks," American Economic Review, American Economic Association, vol. 88(3), pages 587-597, June.
  2. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
  3. Obstfeld, Maurice, 1986. "Rational and Self-fulfilling Balance-of-Payments Crises," American Economic Review, American Economic Association, vol. 76(1), pages 72-81, March.
  4. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
  5. Craig Burnside & Martin Eichenbaum & Sergio T. Rebelo, 2000. "On the Fundamentals of Self-Fulfilling Speculative Attacks," NBER Working Papers 7554, National Bureau of Economic Research, Inc.
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  14. Velasco, Andres, 1987. "Financial crises and balance of payments crises : A simple model of the southern cone experience," Journal of Development Economics, Elsevier, vol. 27(1-2), pages 263-283, October.
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  16. Allen, Franklin & Gale, Douglas, 2000. "Optimal currency crises," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 53(1), pages 177-230, December.
  17. V. V. Chari & Patrick J. Kehoe, 2000. "Financial crises as herds," Working Papers 600, Federal Reserve Bank of Minneapolis.
  18. Miller, Victoria, 1996. "Speculative currency attacks with endogenously induced commercial bank crises," Journal of International Money and Finance, Elsevier, vol. 15(3), pages 383-403, June.
  19. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
  20. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
  21. 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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