Sachs, Jeffrey, and Harry Huizinga, “U.S. Commercial Banks and the Developing-Country Crisis,” Brookings Papers on Economic Activity, 2 (1987), The Brookings Institution (Washington).
I am indebted to comments from colleagues in the Research Department and Paul Collier, Carlos Rodriguez, and Maurice Scott.
All these arguments are frequently put informally and the aim here is to give them some rigorous content. The argument that the incentive effect of debt relief (called the pro-incentive effect in this paper) provides a justification for creditors to provide relief has been put by Jeffrey Sachs in several papers. See, for example, Sachs and Huizinka (1987), pp. 594-95.
It is simplest to assume that there is no private capital inflow or capital outflow (capital flight) during periods 2 or 3. This simplifying assumption, unrealistic for some countries, does not alter the main argument. It will be reconsidered at the end.
Investment might be defined as gross or net. If it were defined as net, output in period 3 resulting from zero investment in period 2 (A’A in Figure 1) would presumably be equal to or greater than period 2 output A’A.
One is tempted to draw an indifference curve through K (rather than at K) but, since there is a minimum consumption level, it should probably not go on below K or should become horizontal.
It would also include direct income of the government, out of which debt service payments could be financed. The horizontal axis would show consumption and domestic savings, and the latter could be invested at home or abroad. By contrast, in the main analysis, domestic savings and domestic investment were always equal.