The role of the central bank in managing expectations, backing up public debt, and controlling public deficits

Can a central bank prevent self-fulfilling debt crises without creating a moral hazard problem? This paper examines this question by presenting a public debt model with self-fulfilling debt crises. In it, the central bank can prevent such self-fulfilling prophecies by announcing purchases of public debt that do not materialize at the equilibrium and that are credible even with imperfect or no commitment. However, a backstop policy creates a moral hazard problem. That is, the government may be tempted to increase its deficit because the central bank's policy of averting self-fulfilling debt crises reduces the probability of public debt repudiation and the associated costs. To avoid this, the central bank can design an optimal incentive contract along with a credible threat policy consisting of reducing its interventions in the debt market. This policy would mitigate or even eliminate the moral hazard problem. • The paper presents a model in which self-fulfilling public debt crises arise. • The central bank can avert, under certain circumstances, self-fulfilling debt crises through credible announcements of public debt purchases that are never implemented. • The optimal central bank’s credible backup policy is presented. • A moral hazard problem arises when the central bank averts self-fulfilling debt crises, which makes the government tempted to increase the deficit. • If the central bank does not impose conditionality, the government will raise the deficit beyond the level that it would have reached in the absence of the central bank’s backup policy. • The central bank may solve the moral hazard problem by imposing conditionality on the government through a combination of optimal credible threats and an incentive-compatible contract.