Exercise 13.5

Moral Sanctions

⬅ Return

Problem

Consider another variant of the model with direct sanctions of Section 13.3.3. Suppose that direct sanctions are not possible, that is, \(k=0\). Instead, assume that defaulting countries experience a self-inflicted moral punishment. Specifically, assume that the utility of the country that defaults in state \(\epsilon\) is given by \(u(y+\epsilon)-m,\) where \(m>0\) is a parameter defining the severity of the moral punishment.

1. Write the incentive-compatibility constraint.

2. Characterize the optimal debt contract \(d(\epsilon)\) and compare it to the one corresponding to the case of direct sanctions.

Answer

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