SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

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

JEL-codes: F34; F40

40 pages, First version: May 20, 2002. Revised: October 8, 2004. Earlier revisions: October 31, 2003, September 2, 2003, November 3, 2003, October 3, 2004, October 3, 2004, October 8, 2004.

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