High Public Debt in Currency Crises : Fundamentals versus Signaling Effects

This paper examines how public debt, government credibility and external circumstances affect the probability of currency devaluations in a three-period, open-economy version of the Barro-Gordon (1983) model. Nominal public debt links current to future policy actions: resisting a crisis may either enhance or undermine the sustainability of the exchange rate regime depending on whether what matters is the government's reputation or fundamentals, i.e.\ the level of the debt. The focus is on the impact of public debt, debt maturity and the government's credibility on the expected devaluation in the current and future periods. We can thus identify the factors that affect the short-term interest rate and the forward rate, hence derive predictions about the level and the slope of the yield curve.