Essays on Bailouts

In this dissertation, I study the optimal finance of bailouts that accelerate the recapitalization of the production sector in a crisis as well as the effects of anticipated bailouts on ex-ante risk-taking in the private sector.

Chapter - 1 studies the optimal way to finance bailouts, given the currency composition of external debt. Motivated by the recently growing domestic currency share of external government debt in the developing world, this chapter proposes that bailouts can be financed both through income taxes and through an inflation tax that reduces the real value of nominal liabilities to foreign lenders. The policymaker trades off the benefits and costs of the inflation tax. The cost includes distortionary effects on labor demand as well as the higher real external debt of the private sector as the exchange rate depreciates faster than prices rise. The quantitative analysis shows that the policymaker is more inclined to impose an inflation tax on international lenders than to collect income taxes from households to alleviate the undercapitalization of the production sector. Adding the inflation tax as a policy tool raises welfare gains significantly. Anticipated bailouts lead bank-firms to build-up higher leverage in pre-crisis that eventually gives rise to a worse contraction. Capital controls offset dilution risks and ex-ante moral hazard issues, thereby reducing the scale of bailouts in a crisis as well as the frequency of a crisis.

Chapter - 2 studies the optimal recapitalization of corporations in a financial crisis under the presence of the informal economy. The policymaker can finance the recapitalization through a combination of income taxes, but agents operating the informal production technology can evade income taxes at no cost, and an inflation tax on money holdings used for transactions. The quantitative analysis reveals that the growing size of the informal economy calls for a more considerable inflation tax to accelerate the recapitalization of corporations. Despite the currency mismatch effects, this policy significantly raises welfare gains. Besides, capital inflow taxes are not optimal, and expansionary fiscal policies are not effective in recovering from a financial crisis under the presence of the informal economy.

Chapter - 3 studies the interaction between the effectiveness of bailouts in assuring ex-post financial stability and the currency composition of sovereign debt. In particular, the chapter studies how ex-ante risk-taking in the production sector affects the currency composition of government debt and vice-versa. The policymaker can hedge against adverse financial shocks by growing the share of debt in domestic currency and thereby can tax foreign lenders to bail out the production sector in a crisis. The quantitative analysis reveals that the production sector builds up higher leverage as the share of the domestic currency debt grows. Higher leverage leading to a more severe crisis eventually calls for a higher inflation tax to finance bailouts. International lenders anticipating debt dilution risks lend at a lower price, thereby the policymaker tilts the currency composition of debt to foreign currency as a response.