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Self-Fulfilling Debt Dilution: Maturity and Multiplicity in Debt Models

Mark Aguiar and Manuel Amador
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Mark Aguiar: Princeton University

No 565, Staff Report from Federal Reserve Bank of Minneapolis

Abstract: 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)
New Economics Papers: this item is included in nep-dge, nep-knm and nep-opm
Date: 2018-05-30
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmsr:565

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DOI: 10.21034/sr.565

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