Staff Report 307

Competitive Equilibria With Limited Enforcement

Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
Fabrizio Perri | Assistant Director and Monetary Advisor

Revised September 1, 2003

We show how to decentralize constrained efficient allocations that arise from enforcement constraints between sovereign nations. In a pure exchange economy, these allocations can be decentralized with private agents acting competitively and taking as given government default decisions on foreign debt. In an economy with capital, these allocations can be decentralized if the government can tax capital income as well as default on foreign debt. The tax on capital income is needed to make private agents internalize a subtle externality. The decisions of the government can arise as an equilibrium of a dynamic game between governments.

Published In: Journal of Economic Theory (Vol. 119, No. 1, November 2004, pp. 184-206)

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