Preventing Self-fulfilling Debt Crises: A Global Games Approach

Abstract

This paper develops a micro-founded global game model of debt crises. I use this model to study which policies can help to prevent expectations-driven crises and how the desirability of such policies depends on market participants' expectations and the presence of economic policy uncertainty. I show that endogenous expectations amplify the effects of government policies so that even a small policy adjustment can have significant effects. I find that policy uncertainty affects the range of situations in which government policies can help prevent a crisis, but decreases their overall impact. Finally, I apply these insights to study two policies that are often at the center of political discussions: an austerity and a government stimulus. I show that under plausible conditions an increase in taxes is a preferable to government stimulus, and that policy uncertainty further increases the relative attractiveness of austerity.