Public debt sustainability in a target zone model with heterogeneous agents

Abstract

Relying on the assumption of perfect information and agent homogeneity, previous interest rate target zone models could well account for situations of government debt stability (‘honeymoon’) or instability (‘divorce’). In those models, however, the transition from one state to another could only occur with a discrete change in the interest rate and thus could not account for the gradual transition from ‘honeymoon’ to ‘divorce’ that occurred in the months leading up to the euro area crisis of 2011–12. The assumption of heterogeneous agents made in this interest rate target zone model, on the other hand, allows that graduality to be represented. Heterogeneous agents are assumed to be characterized by normally distributed beliefs about the maximum sustainable level of the debt-to-GDP ratio. When public debt increases due to an assumed process of stochastic shocks, therefore, the percentage of agents sharing the belief that they have entered a region of instability also increases, thus leading to the gradual transition from ‘honeymoon’ to ‘divorce,’ observed in the euro area crisis of 2011–2012.