Competitive runs on Government debt

Abstract

We study how limiting Government bonds redemptions may precipitate a run. We consider an economy where infinitely-living Government bonds finance the public sector which contributes to output that moves according to a geometric Brownian motion. Agents are heterogeneous, some, Investors, holding bonds directly, others, Depositors, holding deposits in a bank that, in turn, hold bonds. When output faces a negative shock agents have the incentive to sell bonds. Bond sales continue gradually until a floor is reached and the Government stops buying them. The presence of a floor may trigger a run as competing agents attempt to sell before the others. Our model captures the interdependence between heterogenous agents’ exits decisions when a negative shock propagates both within a group and from one group to the other and to the bank. We show how the level of uncertainty determines whether Depositors or Investors exit first, whether exit is sequential, which group runs, whether an economy with financial intermediation is more resilient than one without.