Debt Stabilization Games in the Presence of Risk Premia

Abstract: As a result of the recent financial crisis and the ensuing economic recession, fiscal deficits have soared in many OECD countries. As a consequence, government debt has been on the rise again after a period of stable or declining government debt. In this paper we analyze debt stabilization in a country that features endogenous risk premia, imposed by financial markets that evaluate the probability of debt default by governments. Endogenous risk premia arise by assuming e.g. simple linear relations between risk premia and the level of debt. As a result the real interest rate on government debt can be written as a constant (measuring the risk-free real interest rate corrected for real output growth) plus an endogenous risk premium that depends on the debt level. We bring such endogenous risk premia into the Tabellini (1986) model [22] and analyze the impact of it. This gives rise to a nonlinear differential game. We solve this game for both a cooperative setting and a non-cooperative setting. The non-cooperative game is solved under an open-loop information structure. In particular we present a bifurcation analysis w.r.t. the risk premium parameter.