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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.

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File URL: http://www.nber.org/papers/w1880.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1880.

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Date of creation: Apr 1986
Date of revision:
Publication status: published as "Country Risk, Incomplete Information, and Taxes on International Borrowing." From Economic Journal, Vol. 99, No. 394, pp. 147-161,(March 1989).
Handle: RePEc:nbr:nberwo:1880
Note: ITI IFM
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  1. Harberger, Arnold C, 1980. "Vignettes on the World Capital Market," American Economic Review, American Economic Association, vol. 70(2), pages 331-37, May.
  2. 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.
  3. Maurice Obstfeld, 1984. "Capital Controls, The Dual Exchange Rate, and Devaluation," NBER Working Papers 1324, National Bureau of Economic Research, Inc.
  4. Fumio Hayashi, 1985. "Tests for Liquidity Constraints: A Critical Survey," NBER Working Papers 1720, National Bureau of Economic Research, Inc.
  5. 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 114-33, February.
  6. Eaton, Jonathan, 1986. "Lending with costly enforcement of repayment and potential fraud," Journal of Banking & Finance, Elsevier, vol. 10(2), pages 281-293, June.
  7. 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 785-97, September.
  8. Flood, Robert P & Marion, Nancy Peregrim, 1982. "The Transmission of Disturbances under Alternative Exchange-Rate Regimes with Optimal Indexing," The Quarterly Journal of Economics, MIT Press, vol. 97(1), pages 43-66, February.
  9. Sebastian Edwards, 1985. "Country Risk, Foreign Borrowing and the Social Discount Rate in an Open Developing Economy," NBER Working Papers 1651, National Bureau of Economic Research, Inc.
  10. 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.
  11. 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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