Self-fulfilling debt crises

We characterize the values of government debt and the debt's maturity struc ture under which financial crises brought on by a loss of confidence in the government can arise within a dynamic, stochastic general equilibrium mode l. We also characterize the optimal policy response of the government to th e threat of such a crisis. We show that when the country's fundamentals pla ce it inside the crisis zone, the government may be motivated to reduce its debt and exit the crisis zone because this leads to an economic boom and a reduction in the interest rate on the government's debt. We show that this reduction can be gradual if debt is high or the probability of a crisis Is low. We also show that, while lengthening the maturity of the debt can shr ink the crisis zone, credibility-inducing policies can have perverse effect s.