Financial crises and political crises

Abstract

The simultaneous determination of financial default and political crises is studied in an open economy model. Political crises accompany default in equilibrium because of an information transmission conflict between the government and the public. Multiple equilibria are possible: if foreign lenders are pessimistic about the country's stability, they demand a high interest on the debt, exacerbating distortions and possibly leading to political crisis; but if lenders are optimistic, the cost of the debt falls and political crises disappear. In such a case, international liquidity packages can select the best equilibrium and rule out political crises at negligible cost.