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Welfare analysis of currency regimes with defaultable debts

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Author Info

  • Araujo, Aloisio
  • Leon, Marcia
  • Santos, Rafael

Abstract

We modify the Cole and Kehoe model by including domestic debt. According to the original model, a speculative attack on a high debt level issued abroad triggers external debt default. Here, it is possible to inflate away the domestic debt to avoid the external debt default. We consider two possibilities for domestic debt denomination: (i) local currency and (ii) common currency. In the second case, inflation depends on a monetary union decision. Our numerical results show that to have a debt share denominated in a common currency is optimal when the refinancing risks are highly correlated across union members. Otherwise, the best is to keep the domestic debt denominated in local currency. Finally, the extreme case of having all debt issued abroad and denominated in a foreign currency is suitable when, under alternative regimes, suboptimal inflation motivated by political factors is likely. Although the paper was originally developed for emerging market economies, it sheds some light on the recent Eurozone crisis.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 89 (2013)
Issue (Month): 1 ()
Pages: 143-153

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Handle: RePEc:eee:inecon:v:89:y:2013:i:1:p:143-153

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Web page: http://www.elsevier.com/locate/inca/505552

Related research

Keywords: Dollarization; Optimum currency area; Speculative attacks; Debt crisis;

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References

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  1. Yue, Vivian Z., 2010. "Sovereign default and debt renegotiation," Journal of International Economics, Elsevier, vol. 80(2), pages 176-187, March.
  2. Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
  3. Neumeyer, Pablo Andres, 1998. "Currencies and the Allocation of Risk: The Welfare Effects of a Monetary Union," American Economic Review, American Economic Association, vol. 88(1), pages 246-59, March.
  4. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Interest Rates and Political Uncertainty in Emerging Markets," Working Papers 2006-02, Banco de México.
  5. Harold L. Cole & Timothy J. Kehoe, 1996. "A self-fulfilling model of Mexico's 1994-95 debt crisis," Staff Report 210, Federal Reserve Bank of Minneapolis.
  6. Cole, Harold L & Kehoe, Timothy J, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Wiley Blackwell, vol. 67(1), pages 91-116, January.
  7. Cole, Harold L. & Kehoe, Timothy J., 1996. "A self-fulfilling model of Mexico's 1994-1995 debt crisis," Journal of International Economics, Elsevier, vol. 41(3-4), pages 309-330, November.
  8. Aloisio Pessoa de Araújo & Márcia Saraiva Leon, 2002. "Ataques Especulativos sobre Dívidas e Dolarização," Revista Brasileira de Economia, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil), vol. 56(1), pages 7-46, January.
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Cited by:
  1. Du, Wenxin & Schreger, Jesse, 2013. "Local Currency Sovereign Risk," International Finance Discussion Papers 1094, Board of Governors of the Federal Reserve System (U.S.).

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