Working Paper: CEPR ID: DP2862
Authors: Pierpaolo Benigno; Alessandro Missale
Abstract: This Paper examines how public debt, government credibility and external circumstances affect the probability of exchange rate devaluations in a three-period open-economy version of the Barro-Gordon (1983) model with nominal public debt. Public debt creates a link between current and future policy actions: resisting a crisis may enhance or undermine the sustainability of the exchange-rate regime depending on whether the government's reputation or fundamentals ? i.e. the level of public debt ? are critical for sustainability. The focus is on the impact of public debt, debt maturity and government credibility on the expected devaluation for the current and future periods. This allows us to identify factors affecting the short-term interest rate and the forward rate and hence to derive predictions on the level and the slope of the term structure of interest rates.
Keywords: credibility; fixed exchange rates; nominal debt; maturity; yield curve
JEL Codes: E58; F31; F33; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| public debt (H63) | government credibility (H12) |
| government credibility (H12) | sustainability of exchange rate regime (F33) |
| public debt (H63) | likelihood of currency devaluation (F31) |
| government credibility (H12) | likelihood of currency devaluation (F31) |
| defending fixed parity (C62) | debt burden (H63) |
| debt burden (H63) | likelihood of future devaluation (F31) |
| higher public debt levels (H69) | higher likelihood of future devaluation (F31) |
| larger share of short-term debt (G32) | higher likelihood of future devaluation (F31) |
| higher levels of public debt (H69) | higher interest rates (E43) |
| debt burden effect prevails (F34) | flatter yield curve (E43) |
| signaling effects dominate (G41) | steeper yield curve (E43) |