SAFE DEBT, RISKY CAPITAL

We extend the Diamond (1965) model of national debt in two directions. We first introduce technological uncertainty, and then we allow the stock of debt to vary. We study the dynamical equilibria of the resulting stochastic system and we establish conditions for the existence of stationary states which are expressed in terms of invariant distributions. Since conditions that ensure the existence of a stochastic stationary state with positive debt are very restrictive, in this model financial instability is a pervasive phenomenon and allocations are in general dynamically inefficient.