A Debt Rollover Crisis Model - Honoring Alesina, Prati, and Tabellini (1990)

This paper extends the model of Alesina, Prati, and Tabellini (1990) to account for the uncertainty generated by sunspot beliefs. This extension allows self-fullling debt runs and defaults to occur at any time in the future. The analysis provides new insights and leads to results that are similar to those of Cole and Kehoe (1996, 2000), but in a simpler analytical framework. The model implies a rapid fiscal adjustment when the correction needed to bring debt back to a default-free level is relatively small and the probability of default is high. However, if the debt reduction is large and the future is highly discounted, then the adjustment is optimally spread over many periods and, if the probability of a run is low, even a welfare-maximizing government may refrain from reducing its debt.