International Lending of Last Resort and Moral Hazard: A Model of Imf's Catalytic Finance

53 Pages Posted: 5 Dec 2003 Last revised: 2 Sep 2010

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS); University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Bernardo Guimaraes

Yale University - Department of Economics

Nouriel Roubini

New York University - Leonard N. Stern School of Business - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: December 2003

Abstract

It is often argued that the provision of liquidity by the international institutions such as the IMF to countries experiencing balance of payment problems can have catalytic effects on the behavior of international financial markets, i.e., it can reduce the scale of liquidity runs by inducing investors to roll over their financial claims to the country. Critics point out that official lending also causes moral hazard distortions: expecting to be bailed out by the IMF, debtor countries have weak incentives to implement good but costly policies, thus raising the probability of a crisis. This paper presents an analytical framework to study the trade-off between official liquidity provision and debtor moral hazard. In our model international financial 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 the IMF. We show how an international financial institution helps prevent liquidity runs via coordination of agents' expectations, by raising the number of investors willing to lend to the country for any given level of the fundamental. We show that the influence of such an institution is increasing in the size of its interventions and the precision of its information: more liquidity support and better information make agents more willing to roll over their debt and reduces the probability of a crisis. Different from the conventional view stressing debtor moral hazard, we show that official lending may actually strengthen a government incentive to implement desirable but costly policies. By worsening the expected return on these policies, destructive liquidity runs may well discourage governments from undertaking them, unless they can count on contingent liquidity assistance.

Suggested Citation

Corsetti, Giancarlo and Guimaraes, Bernardo and Roubini, Nouriel, International Lending of Last Resort and Moral Hazard: A Model of Imf's Catalytic Finance (December 2003). NBER Working Paper No. w10125. Available at SSRN: https://ssrn.com/abstract=476082

Giancarlo Corsetti

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )

Villa La Fonte, via delle Fontanelle 18
50016 San Domenico di Fiesole
Florence, Florence 50014
Italy

University of Rome III - Department of Economics ( email )

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Rome, 00154
Italy
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Bernardo Guimaraes

Yale University - Department of Economics ( email )

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New Haven, CT 06520-8264
United States

Nouriel Roubini (Contact Author)

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

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New York, NY 10003
United States
212-998-0886 (Phone)
212-995-4218 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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