Abstract
This paper identifies conditions under which the presence of country risk induces a distortion. Optimal domestic and global policies, in the presence of country risk, call for borrowing taxes. If the level of external borrowing is substantial, then the optimal policy is implemented in a system where the private sector cannot borrow abroad directly. Instead, the central bank borrows externally, auctioning the available credit domestically at a demand-determined price. If penalty enforcement costs are positive, global welfare considerations call for an optimal borrowing tax at a rate higher than the optimal borrowing tax from the nationalistic point of view. Copyright 1989 by Royal Economic Society.
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