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Financial Crises and Political Crises

  • Roberto Chang

This paper is an analysis of the simultaneous determination of financial default and political crises and its consequences. It focuses on a small open economy that faces a debt default decision. Crucially, this decision is made by a government that has superior information than the public about the social costs of default. Citizens can dismiss the government, and overrule its default decision, at the cost of a political crisis. If there is a divergence between the objectives of the government and its people, a political crisis may emerge in equilibrium. For this to be the case, the foreign debt must be large enough, and international reserves low. When this political equilibrium is seen as a part of a larger investment problem, there are equilibria in which crises are "only financial," and equilibria in which both default and political crises occur. In some cases, these two kinds of equilibria coexist and, in this sense, a loss of confidence by foreign lenders can exacerbate the likelihood of a political crisis. If so, international intervention in financial markets may ensure financial and political stability at little cost.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11779.

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Date of creation: Nov 2005
Date of revision:
Publication status: published as Chang, Roberto. “Financial Crises and Political Crises.” Journal of Monetary Economics 54 (2007): 2409-2420.
Handle: RePEc:nbr:nberwo:11779
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  1. Roberto Chang & Andres Velasco, 1999. "Liquidity crises in emerging markets: Theory and policy," FRB Atlanta Working Paper No. 99-15, Federal Reserve Bank of Atlanta.
  2. Daron Acemoglu & Simon Johnson & James Robinson & Yunyong Thaicharoen, 2002. "Institutional Causes, Macroeconomic Symptoms: Volatility, Crises and Growth," NBER Working Papers 9124, National Bureau of Economic Research, Inc.
  3. Torsten Persson & Guido Tabellini, 1999. "Political Economics and Public Finance," NBER Working Papers 7097, National Bureau of Economic Research, Inc.
  4. Torsten Persson & Guido Tabellini, . "Political Economics and Macroeconomic Policy," Working Papers 121, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  5. Jonathan Eaton & Raquel Fernandez, 1995. "Sovereign Debt," NBER Working Papers 5131, National Bureau of Economic Research, Inc.
  6. Peter M. Garber & Lars E.O. Svensson, 1994. "The Operation and Collapse of Fixed Exchange Rate Regimes," NBER Working Papers 4971, National Bureau of Economic Research, Inc.
  7. Chang, Roberto & Majnoni, Giovanni, 2002. "Fundamentals, beliefs, and financial contagion," European Economic Review, Elsevier, vol. 46(4-5), pages 801-808, May.
  8. Cukierman, A. & Tommasi, M., 1997. "When does it take a Nixon to go to China?," Discussion Paper 1997-91, Tilburg University, Center for Economic Research.
  9. John Ferejohn, 1986. "Incumbent performance and electoral control," Public Choice, Springer, vol. 50(1), pages 5-25, January.
  10. Roberto Chang, 1999. "Understanding recent crises in emerging markets," Economic Review, Federal Reserve Bank of Atlanta, issue Q2, pages 6-16.
  11. Jeffrey A. Frankel, 2005. "Contractionary Currency Crashes in Developing Countries," NBER Working Papers 11508, National Bureau of Economic Research, Inc.
  12. Stephan Haggard, 2000. "Political Economy of the Asian Financial Crisis, The," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 107.
  13. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
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