This paper presents a continuous‐time model of sovereign debt. In it, a relatively impatient sovereign government's hidden type switches back and forth between a commitment type, which cannot default, and an opportunistic type, which can, and where we assume outside lenders have particular beliefs regarding how a commitment type should borrow for any given level of debt and bond price. In any Markov equilibrium, the opportunistic type mimics the commitment type when borrowing, revealing its type only by defaulting on its debt at random times. The equilibrium features a “graduation date”: a finite amount of time since the last default, after which time reputation reaches its highest level and is unaffected by not defaulting. Before such date, not defaulting always increases the country's reputation. For countries that have recently defaulted, bond prices and the total amount of debt are increasing functions of the amount of time since the country's last default. For countries that have not recently defaulted (i.e., those that have graduated), bond prices are constant.

We consider a general representation of the delegation problem, with and without money burning, and provide sufficient and necessary conditions under which an interval allocation is optimal. We also apply our results to the theory of trade agreements among privately informed governments. For both perfect and monopolistic competition settings, we provide conditions under which tariff caps are optimal. [PUBLICATION ABSTRACT]

We characterize the design of an optimal trade agreement when governments are privately informed about the value of tariff revenue. We show that the problem of designing an optimal trade agreement in this setting can be represented as an optimal delegation problem when a money burning instrument is available. In a specification with quadratic payoffs and a uniform distribution, we find that the tariff cap and the probability of binding overhang are higher when the upper bound of the support distribution is higher and when the support distribution has greater width.

We study the effect of releasing public information about productivity or monetary shocks using a micro-founded macroeconomic model in which agents learn from the distribution of nominal prices. While a public release has the direct beneficial effect of providing new information, it also has the indirect adverse effect of reducing the informational efficiency of the price system. We show that the negative indirect effect can dominate. Thus, the public information release may increase uncertainty about the monetary shock and reduce welfare. We find that the optimal communication policy is always to release either all or none of the information.

We study the optimal trade-off between commitment and flexibility in a consump- tion-savings model. Individuals expect to receive relevant information regarding tastes and thus they value the flexibility provided by larger choice sets. On the other hand, they also expect to suffer from temptation, with or without self-control, and thus they value the commitment afforded by smaller choice sets. The optimal commitment problem we study is to find the best subset of the individual's budget set. This problem leads to a principal-agent formulation. We find that imposing a minimum level of savings is always a feature of the solution. Necessary and sufficient conditions are derived for minimum-savings policies to completely characterize the solution. We also discuss other applications, such as the design of fiscal constitutions, the problem faced by a paternalist, and externalities. Copyright The Econometric Society 2006.

We propose a tractable variant of the open economy neoclassical growth model that emphasizes political economy and contracting frictions. The political economy frictions involve a preference for immediate spending, while the contracting friction is a lack of commitment regarding foreign debt and expropriation. We show that the political economy frictions slow an economy's convergence to the steady state due to the endogenous evolution of capital taxation. The model rationalizes why openness has different implications for growth depending on the political environment, why institutions such as the treatment of capital income evolve over time, why governments in countries that grow rapidly accumulate net foreign assets rather than liabilities, and why foreign aid may not affect growth.

We present a tractable dynamic general equilibrium model of self-fulfilling bank runs, where banks trade capital in competitive and liquid markets but remain vulnerable to runs due to a loss of creditor confidence. We characterize how the vulnerability of an individual bank depends on its leverage position and the economy-wide asset prices. We study the effect of credit easing policies, in the form of asset purchases. When a banking crisis is generated by runs, credit easing can reduce the number of defaulting banks and enhance welfare. When the crisis is driven by fundamentals, credit easing may have adverse consequences.

We establish that creditor beliefs regarding future borrowing can be self-fulfilling, leading to multiple equilibria with markedly different debt accumulation patterns. We characterize such indeterminacy in the Eaton-Gersovitz sovereign debt model augmented with long maturity bonds. Two necessary conditions for the multiplicity are (i) the government is more impatient than foreign creditors, and (ii) there are deadweight losses from default. The multiplicity is dynamic and stems from the self-fulfilling beliefs of how future creditors will price bonds; long maturity bonds are therefore a crucial component of the multiplicity. We introduce a third party with deep pockets to discuss the policy implications of this source of multiplicity and identify the potentially perverse consequences of traditional “lender of last resort” policies.

We characterize optimal taxation of foreign capital and optimal sovereign debt policy in a small open economy where the government cannot commit to policy and seeks to insure a risk averse domestic constituency. The expected tax on capital is shown to vary with the state of the economy, generating cyclicality in investment and debt in an environment where the first best capital stock is a constant. The government's lack of commitment induces a negative correlation between investment and the stock of government debt, a "debt overhang'' effect. If the government discounts the future at a rate higher than the market, then capital oscillates indefinitely at a level strictly below the first best. Debt relief is never Pareto improving and cannot affect the long-run level of investment. Further, restricting the government to a balanced budget can eliminate the cyclical distortion of investment.

We provide conditions for the feasibility of robust Pareto-improving (RPI) policies when markets are incomplete and the interest rate is below the growth rate. We allow for arbitrary heterogeneity in preferences and income risk and a wedge between the return to capital and bonds. An RPI improves risk sharing and can induce a more efficient level of capital. Elasticities of aggregate savings to changes in interest rates are the crucial ingredients to the feasibility of RPIs. Government debt may complement rather than substitute for capital in an RPI. Our analysis emphasizes the welfare-improving qualities of government bonds versus explicit redistribution.