Moral Hazard Effects of Bailing Out Under Imperfect Information

With a four-stage sequential game model, we analyse two bailout policies, one when the government commits ex-ante and another, in which it does not, both to an optimal bailout. We study if each of these policies ameliorate the effects of liquidation on fundamentals, reduce the likelihood of currency crises and affect the financial sector's performance. We show that commitments to bailing out (only if a bad shock occurs) expressly announced before the market forms expectations, has very important implications. First, multiple equilibria can be prevented. Second, in comparison to the outcome with no commitments, the optimal solution with ex-ante commitments yields a smaller devaluation. Finally, the moral hazard effect on effort when committing to bailing out is rather very large when bailing out costs are not considered to be important by the government. The latter result encompasses the results of the related literature where moral hazard effects are of great concern