A Note on the Hybrid Equilibrium in the Besley-Smart Model

Abstract

This note shows that there is always a non-empty set of parameter values for which the hybrid equilibrium in the Besley and Smart(2003) model is unstable in the sense of Cho and Kreps. This set may include all the parameter values for which a hybrid equilibrium exists. For these parameter values, it is shown that a fully separating equilibrium always exists, which is Cho-Kreps stable. In this equilibrium, the good incumbent distorts ?scal policy to signal his type. An implication is that equilibrium in their model is not (generically) unique.