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DEBT STABILIZATION IN THE PRESENCE OF ENDOGENOUS RISK PREMIA: A DYNAMIC GAME APPROACH

  • Tzanis Anevlavis (a1), George Papavassilopoulos (a1), Jacob Engwerda (a2) and Bas van Aarle (a3)
Abstract

This paper focuses on the possibility that financial markets require risk premia on holding sovereign debt of countries that appear vulnerable from a fiscal sustainability perspective. Both the level of debt as well as the rate of change of debt are assumed to impact on the risk premium. We analyze the impact of such an endogenous risk premium in a simple debt game between a monetary and a fiscal player, as introduced by [Tabellini (1986) Journal of Economic Dynamics and Control 10, 427–442]. The risk premium term adds a nonlinearity to the linear model in case risk premia are absent. We analyze outcomes in case of noncooperative open-loop Nash strategies and in case of cooperative strategies and consider the workings of the risk premium as a market-based disciplining device (in case of high debt) and adjustment rewarding device (in case of a declining debt trajectory).

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Corresponding author
Address correspondence to: Jacob Engwerda, Department of Econometrics and O.R., Tilburg University, P.O. Box 90153, 5000 LE Tilburg, The Netherlands; e-mail: j.c.engwerda@uvt.nl.
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We would like to thank two anonymous referees, Guido Tabellini and seminar participants of the 17th ISDG conference for useful comments on a first version of the paper.

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Macroeconomic Dynamics
  • ISSN: 1365-1005
  • EISSN: 1469-8056
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