Revised July 1, 1998
We characterize the values of government debt and the debt’s maturity structure under which financial crises brought on by a loss of confidence in the government can arise within a dynamic, stochastic general equilibrium model. We also characterize the optimal policy response of the government to the threat of such a crisis. We show that when the country’s fundamentals place it inside the crisis zone, the government is motivated to reduce its debt and exit the crisis zone because this leads to an economic boom and a reduction in the interest rate on the government’s debt. We show that this reduction may be quite gradual if debt is high or the probability of a crisis is low. We also show that, while lengthening the maturity of the debt can shrink the crisis zone, credibility-inducing policies can have perverse effects.
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