Proceedings of 9th Annual London Business Research Conference

Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
Optimal Public Debt and Sovereign Default Risk in a LiquidityConstrained Economy
Pao Virojphan
Sovereign default risk currently stimulates reconsidering of on how a country should
oversee its public debt to welfare optimization. This study aims to investigate the dynamic
behavior of optimal public debt and effects of surrounding institutional factors, namely, political
friction and fiscal rules by using dynamic stochastic general equilibrium (DSGE) approach.
Liquidity-constrained household is introduced to emphasize roles of public debt and political
conflicts. Political friction or inefficiency in public policy process arises from political motivation
among agents. Some fiscal rules are simulated to evaluate potential institutional alternatives for
sovereign default risk and political influence mitigation. This study illustrates the calibrated
results by using Thailand socio-economic characteristics. The results show that the optimal
level of public debt in steady state could be slightly negative or a country should have some
reserve to ensure public liquidation. With sovereign default risk expectation, the reserve level is
lower due to the increase in opportunity cost from sovereign risk premium. The political friction
increases average public debt level when there is a negative productivity shock. Lastly, the
public-debt-targeted fiscal rule yields positive effect on welfare while the debt limit fiscal rule
gives insignificant impact to welfare improvement.
Keywords: Public Economics, Sovereign Default Risk, Political Economy, Rules versus
Discretion, DSGE
JEL classification: E62, H3, H5
Field of research: Banking
Pao Virojphan, Faculty of Economics, Thammasat University, 2 Prachan Road, Bangkok, 10200, Thailand,
Email:, Tel: (66) 0894101788, 02-613-2422, Fax: (66) 02-224-9428