Self-Fulfilling Debt Dilution: Maturity and Multiplicity in Debt Models
Mark Aguiar and
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Mark Aguiar: Princeton University
No 565, Staff Report from Federal Reserve Bank of Minneapolis
We establish that creditor beliefs regarding future borrowing can be self-fulfilling, leading to multiple equilibria with markedly different debt accumulation patterns. We characterize such indeterminacy in the Eaton-Gersovitz sovereign debt model augmented with long maturity bonds. Two necessary conditions for the multiplicity are: (i) the government is more impatient than foreign creditors, and (ii) there are deadweight losses from default; both are realistic and standard assumptions in the quantitative literature. The multiplicity is dynamic and stems from the self-fulfilling beliefs of how future creditors will price bonds; long maturity bonds are therefore a crucial component of the multiplicity. We introduce a third party with deep pockets to discuss the policy implications of this source of multiplicity and identify the potentially perverse consequences of traditional “lender of last resort” policies.
Keywords: Sovereign debt; Self-fulfilling debt crises; Debt dilution; Multiple equilibria (search for similar items in EconPapers)
JEL-codes: F34 (search for similar items in EconPapers)
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Working Paper: Self-Fulfilling Debt Dilution: Maturity and Multiplicity in Debt Models (2018)
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