Debt crises between a country and an international lender as a two-period game

Kjell Hausken and Jonathan W. Welburn

International Review of Economics & Finance, 2024, vol. 92, issue C, 704-723

Abstract: A two-period game between a country and an international lender is developed. In each period the country can repay debt, borrow from international credit markets, loan from an international lender, or default. The international lender can approve or deny the loan. The risk averse country maximizes a time-discounted utility incorporating its consumption. The international lender maximizes a time-discounted utility which values the country's consumption growth positively, and the debt-to-endowment ratio, the loan-to-endowment ratio, and the default penalty negatively. The subgame perfect equilibria are determined with backward induction. It is shown analytically that a country borrows less from international credit markets if it obtains a loan from an international lender and, intuitively, if its endowment increases. In contrast, the country borrows more if its future endowment (in period 2) can be expected to increase, or its initial borrowing is high. The model is simulated applying empirical data from the 2010 Greek crisis. The simulations illustrate how the country consumes in the two periods depending on whether the international lender approves or denies a loan. The impact is assessed of time discounting, risk aversion, default penalties, the country's endowment, interest rates, how the international lender values various characteristics of the country, and initial borrowing and consumption before the game starts.

Keywords: Game theory; Country; Debt; Loan; Borrow; Default; Consumption; Economic risk; Greece; EU; ECB; IMF; Sensitivity analysis (search for similar items in EconPapers)
JEL-codes: C6 C7 G01 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:92:y:2024:i:c:p:704-723

DOI: 10.1016/j.iref.2024.02.034

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