Does Government Insolvency Imply Speculative Attacks?

The aim is to show how and when government insolvency implies a fixed exchange rate regime crisis. To model these issues I try to unify a stylized macroeconomic model with a standard micro agent behavior toward asset pricing. The equilibrium condition between demand and supply of public debt, the latter coming from the current government budget constraint, shows the vitious circle between debt accumulation, default probabilities and interest payments. In this set up, the Treasury crisis is shown to be driven by two interdependent processes: (i) the rate at which the public debt stock accumulates; (ii) the rate at which the likelihood of default increases, which affects the domestic real interest rate. When the two processes lead debt to accumulate at a rate faster than r, debt accumulates at an increasing rate that reaches infinity in finite time. Under this kind of circumstance, the impossibility to offer the equilibrium return develops the run. An increasing second derivative of debt accumulation process is seen as a possible psycological threshold, that used as signal of default, may start the vitious spiral.