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Country Risk, Asymmetric Information and Domestic Policies


  • Joshua Aizenman


This paper describes an economy where incomplete information regarding the default penalty can result in an upward-sloping supply of credit.We evaluate the role of partial information and other related factors in determining the elasticity of supply of credit and the credit ceiling facing the economy. We identify conditions under which the presence of country risk induces a domestic distortion. Next, we derive the cost-minimizing domestic policies needed in the presence of such a distortion. It is shown that cost-minimizing policies for a country that wishes to service its debt in the presence of country risk calls for a combination of borrowing taxes and time varying consumption taxes. If all consumers have access to the domestic capital market, the two policies are equivalent. If domestic consumers are subject to liquidity constraints, cost-minimizing policies call for a combination of time varying consumption taxes and product subsidies that will mimic the consumption distribution achieved by cost-minimizing policies in the absenceof liquidity constraints. The policies derived in the paper are formulated interms of the country risk, as embodied in the elasticity of supply of credit facing the borrower. In a mixed economy, where some consumers are subject to credit rationing whereas others have full access to the domestic credit market, there is a need for taxes on borrowing as well as time varying consumption and production tax cum subsidies. The analysis also shows that if the level of external borrowing is substantial, cost-minimizing domestic policies call for instituting a two-tier exchange rate system.

Suggested Citation

  • Joshua Aizenman, 1986. "Country Risk, Asymmetric Information and Domestic Policies," NBER Working Papers 1880, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1880
    Note: ITI IFM

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    References listed on IDEAS

    1. Joshua Aizenman, 1986. "On the Complementarity of Commercial Policy, Capital Controls, and Inflation Tax," Canadian Journal of Economics, Canadian Economics Association, vol. 19(1), pages 114-133, February.
    2. Obstfeld, Maurice, 1986. "Capital controls, the dual exchange rate, and devaluation," Journal of International Economics, Elsevier, vol. 20(1-2), pages 1-20, February.
    3. Harberger, Arnold C, 1980. "Vignettes on the World Capital Market," American Economic Review, American Economic Association, vol. 70(2), pages 331-337, May.
    4. Rudiger Dornbusch, 1985. "Policy and Performance Links between LDC Debtors and Industrial Nations," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(2), pages 303-368.
    5. Edwards, Sebastian, 1986. "Country risk, foreign borrowing, and the social discount rate in an open developing economy," Journal of International Money and Finance, Elsevier, vol. 5(1, Supple), pages 79-96, March.
    6. Harberger, Arnold C, 1971. "Three Basic Postulates for Applied Welfare Economics: An Interpretive Essay," Journal of Economic Literature, American Economic Association, vol. 9(3), pages 785-797, September.
    7. Adams, Charles & Greenwood, Jeremy, 1985. "Dual exchange rate systems and capital controls: An investigation," Journal of International Economics, Elsevier, vol. 18(1-2), pages 43-63, February.
    8. Robert P. Flood & Nancy Peregrim Marion, 1980. "The Transmission of Disturbances under Alternative Exchange-Rate Regimeswith Optimal Indexing," NBER Working Papers 0500, National Bureau of Economic Research, Inc.
    9. Eaton, Jonathan, 1986. "Lending with costly enforcement of repayment and potential fraud," Journal of Banking & Finance, Elsevier, vol. 10(2), pages 281-293, June.
    10. Robert P. Flood & Nancy Peregrim Marion, 1982. "The Transmission of Disturbances under Alternative Exchange-Rate Regimes with Optimal Indexing," The Quarterly Journal of Economics, Oxford University Press, vol. 97(1), pages 43-66.
    11. Fumio Hayashi, 1985. "Tests for Liquidity Constraints: A Critical Survey," NBER Working Papers 1720, National Bureau of Economic Research, Inc.
    12. Scheinkman, Jose A & Weiss, Laurence, 1986. "Borrowing Constraints and Aggregate Economic Activity," Econometrica, Econometric Society, vol. 54(1), pages 23-45, January.
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    Cited by:

    1. Helmut Krämer-Eis, 1998. "Evaluierung hoheitlicher Länderrisiken," Working Paper Series B 1998-01, Friedrich-Schiller-Universität Jena, Wirtschaftswissenschaftliche Fakultïät.
    2. Philipp Harms & Michael Rauber, 2004. "Foreign aid and developing countries' creditworthiness," Working Papers 04.05, Swiss National Bank, Study Center Gerzensee.

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