We explore the role of inflation credibility in self-fulfilling debt crises. In particular, we propose a continuous time model of nominal debt with the potential for self-fulfilling debt crises as in Calvo (1988) and Cole and Kehoe (2000). We characterize crisis equilibria conditional on the level of commitment to low inflation. With strong commitment, which can be interpreted as joining a monetary union or issuing foreign currency debt, the environment is a version of the one studied by Cole and Kehoe. The paper contrasts this framework with one in which sovereign debt is nominal and is vulnerable to ex post devaluation. Inflation is costly, but reduces the real value of outstanding debt without the full punishment of default. In a debt crisis, a government may opt to inflate away a fraction of the real debt burden rather than explicitly de-fault. This flexibility potentially reduces the country's exposure to self-fulfilling crises. On the other hand, the government lacks commitment not to inflate in the absence of crisis. This latter channel raises the cost of debt in tranquil periods and makes default more attractive in the event of a crisis, increasing the country's vulnerability. We characterize the interaction of these two forces. We show that there is an intermediate level of commitment that minimizes the country's exposure to rollover risk. On the other hand, low inflation credibility brings the worst of both worlds high inflation in tranquil periods and increased vulnerability to a crisis. Weak inflationary commitment also reduces the country's equilibrium borrowing limit. These latter results shed light on the notions of original sin and debt intolerance highlighted in the empirical literature; that is, the fact that developing economies issue debt exclusive in foreign currency to international investors as well as encounter solvency issues at relatively low ratios of debt-to-GDP.
Preliminary October 2012.
We study a small open economy characterized by two empirically important frictions – incomplete ﬁnancial markets and an inability of the government to commit to policy. We characterize the best sustainable ﬁscal policy and show that it can amplify and prolong shocks to output. In particular, even when the government is completely benevolent, the government’s credibility not to expropriate capital endogenously varies with the state of the economy and may be “scarcest” during recessions. This increased threat of expropriation depresses investment, prolonging downturns. It is the incompleteness of ﬁnancial markets and lack of commitment that generate investment cycles even in an environment where ﬁrst best capital stock is constant.