Self-fulfilling crises with default and devaluation

We characterize optimal debt policy in a dynamic stochastic general equilibrium model of defaults and devaluations in which self-fulfilling crises can arise. When the government cannot commit to repay its debt and cannot commit to maintain the exchange rate, consumers’ expectations of devaluation make the safe level of government debt very low. We show that, when the debt is in the crises zone—where self-fulfilling crisis can occur—the government finds it optimal to reduce the debt to exit the zone. The lower the probability that consumers assign to devaluation, however, the greater is the number of periods that the government will choose to take to exit the crisis zone. We argue that our model can help understand events in Argentina in 2001–2002 and throw light on some aspects of the current EMU sovereign debt crisis. Copyright Springer-Verlag 2013