SSE/EFI Working Paper Series in Economics and Finance
No 520:
Financial Crisis in Emerging Markets and the Optimal Bailout Policy
Rudolfs Bems ()
and Kristian Jönsson ()
Abstract: This paper develops a framework for analyzing optimal
government bailout policy in a dynamic stochastic general equilibrium model
where financial crises are exogenous. Important elements of the model are
that private borrowers only internalize part of the social cost of foreign
borrowing in the emerging market and that the private sector is illiquid in
the event of a crisis. The distinguishing feature of our paper is that it
addresses the optimal bailout policy in an environment where there are both
costs and benefits of bailouts, and where bailout guarantees potentially
distort investment decisions in the private sector. We show that it is
always optimal to commit to a bailout policy that only partially protects
investment against inefficient liquidation, both in a centralized economy
and a market economy. Due to overinvestment in the market economy, the
government’s optimal level of bailout guarantees is lower than in the
social optimum. Further, we show that, in contrast to a social planner, the
government in the market economy should optimally bail out a smaller
fraction of private investments when the probability of a crisis
increases.
Keywords: financial crisis; government bailout; emerging markets; (follow links to similar papers)
JEL-Codes: F34; F40; (follow links to similar papers)
40 pages, May 20, 2002, Revised October 8, 2004
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