We characterize the values of government debt and the debt's maturity structure under which financial crises brought on by a loss of confidence in the government can arise within a dynamic, stochastic general equilibrium model. We also characterize the optimal policy response of the government to the threat of such a crisis. We show that when the country's fundamentals place it inside the crisis zone, the government may be motivated to reduce its debt and exit the crisis zone because this leads to an economic boom and a reduction in the interest rate on the government's debt. We show that this reduction can be gradual if debt is high or the probability of a crisis is low. We also show that, while lengthening the maturity of the debt can shrink the crisis zone, credibility-inducing policies can have perverse effects. Financial crises brought on by a loss of confidence in the government can arise suddenly and threaten countries with huge losses. We analyse the conditions that make these crises possible and what policy makers should do in the face of this kind of risk. To address these issues, we examine optimal government policy in a dynamic, stochastic general equilibrium model in which self-fulfilling crises can arise. Because of the government's need to roll over its debt, a liquidity crunch induced by the inability to sell new debt can lead to a self-fulfilling default. We show that, if fundamentals like the level of the government's debt, its maturity structure, and the private capital stock, lie within a particular range (the crisis zone), then the probability of default is determined by the beliefs of market participants. We show that a government is motivated to reduce its debt and exit the crisis zone because doing so leads to an economic boom and a reduction in the interest rate on the government's debt. The distinguishing feature of this paper is that it examines optimal policy within an environment in which not only can crises occur in the first period, but crises can occur in subsequent periods with positive probability. This is important since we show that previously proposed policies that seek to avert a crisis by reacting contemporaneously, such as pegging the interest rate on the government debt or lengthening the maturity of the debt being sold once a crisis has started, are ineffectual in our model. Instead, it is only preemptive policies, which seek to remove the conditions that make future crises possible, that can be effective. To examine optimal debt policy, we construct a time-consistent equilibrium of our model with a (relatively) easy-to-characterize Markov structure in which a crisis can occur with a positive probability whenever the level and maturity structure of the government's debt and the capital stock are in the crisis zone. We show that within the crisis zone, the
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