International lending of last resort and moral hazard: A model of IMF's catalytic finance [An article from: Journal of Monetary Economics]

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Description:
This paper analyzes the trade-off between official liquidity provision and debtor moral hazard in international financial crises. In the model, crises are caused by the interaction of bad fundamentals, self-fulfilling runs and policies by three classes of optimizing agents: international investors, the local government and an international official lender. Limited contingent liquidity support helps to prevent liquidity runs by raising the number of investors willing to lend to the country for any given fundamentals, i.e., it can have catalytic effects. The influence of the official lender is increasing in the size of its interventions and the precision of its information. Unlike the conventional view stressing debtor moral hazard, our model identifies circumstances in which official lending actually strengthens a government's incentive to implement desirable but costly policies.