Sovereign Borrowing for Dubious Reforms: A model with applications on the EMU
This paper presents a model where governments need loans to ﬁnance reforms and may misuse these funds for consumption without immediately exposing this to its lenders. Such a misuse is ultimately followed by a sovereign default, therefore lenders will try to discipline governments in favor of true reforms. This puts a government and its lenders in a sequential game, which has two remarkable properties: First, discipling a government in favor of reforms may work, albeit far from perfect. Second, the game implies jumps in the interest rate as observed in the EMU debt crisis.
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