Government guarantees and self-fulfilling speculative attacks

Craig Burnside, Martin Eichenbaum*, Sergio Rebelo

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

55 Scopus citations

Abstract

We develop a model in which government guarantees to banks' foreign creditors are a root cause of self-fulfilling twin banking-currency crises. Absent guarantees, such crises are not possible. In the presence of guarantees banks borrow foreign currency, lend domestic currency and do not hedge the resulting exchange rate risk. With guarantees, banks will also renege on their foreign debts and declare bankruptcy when a devaluation occurs. We assume that the government is unable or unwilling to fully fund the resulting bailout via an explicit fiscal reform. These features of our model imply that government guarantees lead to self-fulfilling banking-currency crises.

Original languageEnglish (US)
Pages (from-to)31-63
Number of pages33
JournalJournal of Economic Theory
Volume119
Issue number1
DOIs
StatePublished - Nov 1 2004

Keywords

  • Debt denomination
  • Fixed exchange rate regimes
  • Government guarantees
  • Hedging

ASJC Scopus subject areas

  • Economics and Econometrics

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