A Debt Management Problem with Currency Devaluation

TL;DR

This paper models sovereign debt management considering currency devaluation and bankruptcy, analyzing optimal policies and equilibrium states with social costs and welfare implications.

Contribution

It introduces a dynamic model combining debt management, currency devaluation, and bankruptcy decisions, providing equilibrium analysis of sovereign debt strategies.

Findings

Existence of equilibrium solutions with bankruptcy or stationary states

Optimal policies depend on initial conditions and social costs

Model captures trade-offs between debt reduction and welfare sustainability

Abstract

We consider a model of debt management, where a sovereign state trade some bonds to service the debt with a pool of risk-neutral competitive foreign investors. At each time, the government decides which fraction of the gross domestic product (GDP) must be used to repay the debt, and how much to devaluate its currency. Both these operations have the effect to reduce the actual size of the debt but have a social cost in terms of welfare sustainability. Moreover, at any time the sovereign state can declare bankruptcy by paying a correspondent bankruptcy cost. We show that these optimization problems admits an equilibrium solution, leading to bankruptcy or to a stationary state, depending on the initial conditions.