Investment necessary for growth is risky and often requires external financing. For an emerging market, access to international credit markets is volatile and interest rates reflect risk of default. We present a model in which emerging market agents have access to a profitable two-period investment project of fixed size greater than their endowment. Credit market imperfections can magnify a small solvency problem into a financial crisis with widespread default and/or currency devaluation. In equilibrium, creditors offer single-period debt up to a ceiling based on expected future output. News about a negative productivity shock reduces the debt ceiling imposed by creditors, creating a sudden stop of capital flows. The sudden stop can be severe enough to trigger a debt crisis, when agents prefer default over debt repayment, and/or a currency crisis, as agents attempt to maintain desired consumption by swapping domestic currency for foreign currency to purchase goods. We also show that there are critical thresholds for parameters governing credit market imperfections that separate countries into a safe credit club with low interest rates and steady access and a risky club with high interest rates and volatile access.
A country entering a monetary union gives up
the right to determine its own monetary policy, thereby relinquishing monetary
instruments to assure fiscal solvency. When debt is subject to an upper bound
and policy faces stochastic shocks, a government can find itself in a position
for which the expected present value of future surpluses under current policy
is less than debt. This paper considers the risk of a fiscal financial crisis
in a monetary union under alternative assumptions about how the fiscal authority
would respond. We simulate the model to obtain estimates of fiscal risk in the
European Monetary Union.
The Fiscal Theory of the Price Level and Initial Government Debt (April, 2007), Review of Economic Dynamics
It is widely believed that the Fiscal Theory of the Price Level (FTPL) does not work in an environment in which initial government debt is zero. This paper demonstrates that this view is incorrect when asset markets are incomplete and fiscal policy is stochastic. In particular, it is possible to define a stochastic non-Ricardian fiscal policy for which the set of equilibrium stochastic price processes under non-Ricardian fiscal policy is a subset of the set of equilibrium stochastic price processes under Ricardian fiscal policy.
Financial Liberalization and Banking Crises in Emerging Economies
co-authored with John Jones (May, 2007), Journal of International Economics.
Financial liberalization often leads to financial crises. This link has usually been attributed to poorly designed banking systems, an explanation that is largely static. In this paper we develop a dynamic explanation, by modeling the evolution of a newly-liberalized bank's opportunities and incentives to take on risk over time. The model reveals that even if a banking system is well-designed, in the sense of having good long-run properties, many countries will enjoy an initial period of rapid, low-risk growth and then enter a period with an elevated risk of banking crisis. This transition emerges because of the way in which the degree of foreign competition, the marginal product of capital, and the bank's own net worth simultaneously evolve.
Public Default Dynamics (revised –August 2006)
This paper provides a dynamic model of a
public debt crisis in which fiscal insolvency is the cause. The insolvency is
created by a combination of a passive fiscal policy with an upper bound on the
long-run budget surplus, yielding risky government debt, and a string of bad
luck. As debt rises and a crisis approaches, the interest rate rises, due to a
risk premium on debt in anticipation of possible default. A position, in which
the contractual value of debt under passive fiscal policy exceeds the maximum
expected present-value surplus, is infeasible. Should passive fiscal policy
require such a point, a crisis occurs. Crisis resolution includes a promise of
fiscal reform, with a switch to active fiscal policy as in the Fiscal Theory of
the Price Level (FTPL). The switch creates larger near-term surpluses, which
serve to raise the expected present-value surplus, and greater exchange rate
flexibility, which eliminates the default premium on debt. If the present-value
surplus is still too low relative to debt after the policy switch, default is
necessary.
Monetary Policy in a Fiscal
Theory Regime (June 2004)
This paper considers the behavior of monetary
policy in a regime in which the "Fiscal Theory of the Price Level"
(FTPL) applies and in which the government issues long-term debt. Cochrane
(2001) shows that the fiscal authority can use a commitment to maintain a fixed
maturity structure of government debt to fully determine the impact and dynamic
effects of present-value-surplus shocks on inflation in a cashless economy. We
show that in a monetary economy, in which Cochrane’s fiscal commitment to
maturity structure is replaced with a monetary commitment to a state-contingent
interest rate rule, the monetary authority becomes responsible for the timing
of inflation. We derive interest rate rules, which minimize the variance of
inflation around a target, and show that the interest rate will respond
positively to shocks raising inflation and to shocks raising output above
trend, as with a Taylor Rule.