Abstract
We propose a joint theory for interest rate dynamics and bailout decisions. Interest rate spreads are driven by time-varying fundamentals and expectations of future bailouts. Private agents are uncertain about the government's willingness to bail out and learn by observing its actions. The model provides an explanation for why we observe governments initially refusing to bail out borrowers at the beginning of a crisis even if they eventually end up providing a bailout after the crisis aggravates. The typical equilibrium outcome displays hump-shaped spreads and contagion as was the case in the US financial and European debt crises. (JEL E43, G01, G21, H63, H81)
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