Self-Fulfilling Debt Dilution

Debt
Self-Fulfilling Debt Dilution:
Maturity and Multiplicity
in Debt Models

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In a recent working paper published by the Federal Reserve Bank of Minneapolis, Mark Aguiar and Manuel Amador establish that creditor beliefs regarding future borrowing can be self-fulfilling. The recent sovereign debt crisis in Europe, along with the associated policy responses, underscores the importance of understanding self-ful€lling debt crises. Aguiar and Amador create a tractable version of the Eaton-Gersovitz sovereign debt model to better determine under what circumstances self-ful€lling debt crises occur.

The paper concludes by showing that debt dilution generates multiplicity in a standard sovereign debt framework. Specifically, the multiplicity of equilibria depends on the impatience of the government, the intermediate debt maturity, and the deadweight losses from default. Importantly, these are common features of observed debt markets as well as in the recent quantitative models proposed in the literature.

 

Mark Aguiar is the Walker Professor of Economics and International Finance at Princeton University

Manuel Amador is a Professor in the Department of Economics at the University of Minnesota

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