Rational expectations and the service of public debt: A recursive approach

The financial turmoil of emerging markets at the end of the 1990s suggest that unsustainable public deficits play an important role in these crises. Permanent deficits pose a threat to government credibility and lead to dynamically inconsistent macroeconomic policies, such as inflation or default on public debt. This dissertation uses dynamic programming to study the role of rational expectations in equilibrium determination in economies with recurring public deficits. To this end, a general equilibrium, infinite-horizon, recursive theoretical model based on Chang (1998) and Calvo (1988) is developed. The model analyzes the Sargent-Wallace (1981) problem: recurring deficits may lead the government to default on part of its public debt. The setting in Chang (1998) is an economy with money and transfers only, and implies that the need for government financing through inflation tax is minimal. The Calvo (1988) two-period model introduces government expenditure and deficit financing through the sale of government bonds, and allows for two equilibria. Rational expectations can lead the economy to the Pareto inferior one, with high inflation and interest rates, a dynamically inconsistent result. The hybrid model allows for the computation of the set of all time consistent policies, defined as sustainable plans, even when the government cannot pre-commit. This is obtained through value function iterations done on a computer. The parameters of the new model are calibrated with Brazilian data, using as case study some Brazilian stabilization plans. The numerical computation of the extended model proves unfeasible due to a dimensionality problem arising from limitations of available computer technology. A numerical solution to the original algorithm is obtained and results indicate that only the Real Plan is sustainable. The original model works well to explain the Brazilian experience. The numerical solution of the extended algorithm is left for future research.