Annex: Chapter 7

Manmohan Singh

We present a simple extension of the model in Geanakoplos and Wang (2017).11 Readers can refer to Geanakoplos and Wang (2017) for more details about the model setup. The model is abstract and may not be applicable to all practical policy choices. Consider a simple endowment economy with two countries: an AE and an EM. Time is discrete, and there are two periods: t = 0, 1. There are two possible states in period 1: U, D, where U stands for the “Up” state and D for the “Down” state. Agents in both economies consume a single consumption good C. Each economy has two kinds of government bonds. The first is a riskless bond that is analogous to short-term government bonds, such as Treasury bills. The riskless bond pays one unit of money in both U and D, and their payoffs (promises) will be paid by the issuing government from tax revenues. For simplicity, we assume that there is a fixed exchange rate (equal to one) between the AE and the EM. Denote the riskless bond as B.

The second type of government bond is a risky real bond and is analogous to long-term government bonds, whose payoff (eg, par value) can vary across different states in the second period.22 We do not seek to model the

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