PBE Type i: Neither default nor political crisis If V ≤ χL, the costs of default are always larger than the costs of servicing the debt even for the benevolent government. Then in equilibrium, the government proposes to service the debt, which is accepted by the representative agent. Hence the debt is repaid and political crisis is avoided. Neither the benevolent government nor the self interes...

How are the optimal tax and debt policies affected if government can default on its debt? We address this question from a normative perspective in an economy with noncontingent debt, domestic default, labor taxes. On one hand, prevents incurring future distortions associated servicing debt. other risk gives rise to endogenous credit limits that hinder government's ability smooth characterize fi...

We analyze a model of optimal capital structure and liquidity choice based on a dynamic tradeoff theory for financially constrained firms. In addition to the classical tradeoff between the expected tax advantages of debt and bankruptcy costs, we introduce a cost of external financing for the firm, which generates a precautionary demand for liquidity and an optimal liquidity management policy fo...