Working Paper: NBER ID: w2662
Authors: Joshua Aizenman
Abstract: The purpose of this paper is to study the role of policies in the presence of country risk with overdiscounting by the policy maker. Overdiscounting may reflect political uncertainty, which makes the effective planning horizon of the centralized government shorter than that of the private sector. The consequence of overdiscounting is to shift the supply curve facing the economy leftwards. The role of optimal borrowing policies in the presence of country risk is to discourage borrowing for consumption purposes, encourage investment in openness, and discourage investment in activities that reduce openness. The effect of overdiscounting by the policy maker is to increase the values of the optimal policy instruments (i.e. to increase the magnitude of the borrowing taxes and subsidies). Increasing the relative importance of open activities can be viewed as a way to reduce the harmful consequences of overdiscounting. Overdiscounting may rationalize various conditionality clauses that will induce the economy to follow the desired credit market policies.
Keywords: External Debt; Country Risk; Credit Markets; Overdiscounting; Investment Policies
JEL Codes: F34; H63; O16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| overdiscounting by the policy maker (H43) | leftward shift in the supply curve for credit (E51) |
| shorter planning horizon (D25) | increase in the optimal policy instruments (D78) |
| increase in the optimal policy instruments (D78) | discourage borrowing for consumption (G51) |
| increase in the optimal policy instruments (D78) | encourage investment in activities that enhance openness (O35) |
| increasing the economy's openness (F43) | generates positive externalities that bond the country to honor its financial obligations (H63) |
| generating positive externalities (D62) | increasing the supply of credit (E51) |
| distortion from overdiscounting (D15) | policy maker defaults more frequently than optimal for the representative consumer (D72) |
| policy maker's decisions (D78) | do not align with the welfare maximization of the representative agent (D69) |
| necessitating implementation of conditionality clauses (F34) | align incentives (M52) |