Tough Policies, Incredible Policies

CID Faculty Working Paper No. 105

Alejandro Neut and Andrés Velasco
September 2004


We revisit the question of what determines the credibility of macroeconomic policies here, of promises to repay public debt. The literature has focused on governments. strategic decision to default (or erode the value of outstanding debt via inflation/devaluation). It has also focused on increasing policymakers. utility costs as a way to deter strategic misbehavior. By contrast, we build a model in which default or inflation can occur deliberately (for strategic reasons) or unavoidably (shocks leave no other option). In addition, when it does occur, default or inflation entail pecuniary costs, not just utility costs for the policymaker. In the model with these two features, much conventional wisdom on the determinants of credibility need no longer hold. Tough policies such a as appointing a conservative policymaker, indexing public debt or denominating public debt in foreign currency may reduce, not increase, the credibility of vows to repay debt in full. For some parameter values, these tough policies may also reduce welfare.

Keywords: credibility, debt, commitment, crises

JEL subject codes: E5, E6, F3, F4