Staff Report 179

The Role of Institutions in Reputation Models of Sovereign Debt

Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
Harold L. Cole

Published August 1, 1994

A standard explanation for why sovereign governments repay their debts is that they must maintain a good reputation to easily borrow more. We show that the ability of reputation to support debt depends critically on the assumptions made about institutions. At one extreme, we assume that bankers can default on payments they owe to governments. At the other, we assume that bankers are committed to honoring contracts made with governments. We show that if bankers can default, then a government gets enduring benefits from maintaining a good relationship with bankers and its reputation can support a large amount of borrowing. If, however, bankers must honor their contracts, then a government gets only transient benefits from maintaining a good relationship and its reputation can support zero borrowing.

Published In: Journal of Monetary Economics (Vol. 35, No. 1, February 1995, pp. 45-64)

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