Credit Markets , Limited Commitment , and Government Debt ∗ Francesca

A dynamic model with credit under limited commitment is constructed, in which limited memory can weaken the effects of punishment for default. This creates an endogenous role for government debt in credit markets, and the economy can be non-Ricardian. Default can occur in equilibrium, and government debt essentially plays a role as collateral and thus improves borrowers’ incentives. The provision of government debt acts to discourage default, whether default occurs in equilibrium or not. ∗These are our own views, and not necessarily those of the Federal Reserve Banks of Richmond and St. Louis, or the Board of Governors of the Federal Reserve System. We thank seminar and conference participants at the Chicago Federal Reserve Bank Workshop on Money, Banking, and Payments, the 2012 SED Meetings, along with 3 anonymous referees and the editor Dimitri Vayanos, for their helpful comments and suggestions.