Financial Crises and Political Crises∗

The simultaneous determination of financial default and political crises is studied in an open economy model. Political crises accompany default in equilibrium because of an information transmission conflict between the government and the public. Multiple equilibria are possible: if foreign lenders are pessimistic about the country’s stability, they demand a high interest on the debt, exacerbating distortions and possibly leading to political crisis; but if lenders are optimistic, the cost of the debt falls and political crises disappear. In such a case, international liquidity packages can select the best equilibrium and rule out political crises at negligible cost. JEL Classification Numbers: F3, F4 ∗I am indebted to an anonymous referee for very useful suggestions. Also, I thank Daron Acemoglu, Michael Bordo, Charles Engel, Ken Rogoff, Will Roberds, Andres Velasco, and seminar participants at ITAM, NYU, the NY Fed, the World Bank, Columbia, and Princeton for comments and suggestions. Finally, I acknowledge the hospitality and financial support of Princeton University. Of course, any errors or omissions are solely my own. †Department of Economics, Rutgers University, New Brunswick NJ 08901. Phone: (732) 932 7269. Fax: (732) 932 7416. Email: [email protected]