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Slow Moving Debt Crises

  • Guido Lorenzoni
  • Ivan Werning

What circumstances or policies leave sovereign borrowers at the mercy of self-fulfilling increases in interest rates? To answer this question, we study the dynamics of debt and interest rates in a model where default is driven by insolvency. Fiscal deficits and surpluses are subject to shocks but influenced by a fiscal policy rule. Whenever possible the government issues debt to meet its current obligations and defaults otherwise. We show that low and high interest rate equilibria may coexist. Higher interest rates, prompted by fears of default, lead to faster debt accumulation, validating default fears. We call such an equilibrium a slow moving crisis, in contrast to rollover crises where investor runs precipitate immediate default. We investigate how the existence of multiple equilibria is affected by the fiscal policy rule, the maturity of debt, and the level of debt.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19228.

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Date of creation: Jul 2013
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Handle: RePEc:nbr:nberwo:19228
Note: EFG IFM ME
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  1. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
  2. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  3. Cole, Harold L & Kehoe, Timothy J, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Wiley Blackwell, vol. 67(1), pages 91-116, January.
  4. Frankel, David M. & Morris, Stephen & Pauzner, Ady, 2003. "Equilibrium selection in global games with strategic complementarities," Journal of Economic Theory, Elsevier, vol. 108(1), pages 1-44, January.
  5. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
  6. Henning Bohn, 2005. "The Sustainability of Fiscal Policy in the United States," CESifo Working Paper Series 1446, CESifo Group Munich.
  7. Harold L. Cole & Timothy J. Kehoe, 1996. "A self-fulfilling model of Mexico's 1994-95 debt crisis," Staff Report 210, Federal Reserve Bank of Minneapolis.
  8. Chamon, Marcos, 2007. "Can debt crises be self-fulfilling?," Journal of Development Economics, Elsevier, vol. 82(1), pages 234-244, January.
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