We consider a government raising a quantity of debt bt+1 at date t at a price...

    

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We consider a government raising a quantity of debt bt+1 at date t at a price qt < 1. This debt implies a debt repayment in the following period of bt+1. The government has a debt inherited from the previous period bt. At date t, the government also runs a fiscal deficit denoted ft. The government default when it cannot payback its debt. We denote Pt+1 the expected probability that the government defaults on bt+1 (complete default), with 0 ≤ Pt+1 ≤ 1. Explain why the price of debt qt satisfies the following relationship: 1 - Pt+1 1+r qt We assume that Pt+1 is an increasing function of bt+1 satisfying Pt+1(bt+1) = 0 for bt+1 ≤ b₁ and Pt+1(bt+1) = 1 for bt+1 ≥ bH, with 0 < b <bH. What do b, and by represent? Explain why the model can generate multiple equilibria. Comment. How does this model help understanding liquidity crisis in sovereign debt markets? We consider a government raising a quantity of debt bt+1 at date t at a price qt < 1. This debt implies a debt repayment in the following period of bt+1. The government has a debt inherited from the previous period bt. At date t, the government also runs a fiscal deficit denoted ft. The government default when it cannot payback its debt. We denote Pt+1 the expected probability that the government defaults on bt+1 (complete default), with 0 ≤ Pt+1 ≤ 1. Explain why the price of debt qt satisfies the following relationship: 1 - Pt+1 1+r qt We assume that Pt+1 is an increasing function of bt+1 satisfying Pt+1(bt+1) = 0 for bt+1 ≤ b₁ and Pt+1(bt+1) = 1 for bt+1 ≥ bH, with 0 < b <bH. What do b, and by represent? Explain why the model can generate multiple equilibria. Comment. How does this model help understanding liquidity crisis in sovereign debt markets?