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Default Risk and Economic Activity: A Small Open Economy Model with Sovereign Debt and Default

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  • Jessica Roldán-Peña
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    Abstract

    Empirical evidence shows that sovereign defaults are associated with significant downturns in economic activity in defaulting countries. However, the existing literature on sovereign debt and default mainly analyzes endowment economies and, therefore, does not address the relationship between default risk and macroeconomic dynamics. This paper develops a general equilibrium small open economy model with financial frictions that allows to simultaneously examine the behavior of output, investment and borrowing dynamics and its interaction with sovereign default. When calibrated to match the business cycles properties of an average emerging market economy, the model is able to reproduce the countercyclicality of net exports and sovereign spreads and the negative correlation between investment and net exports observed in the data. Furthermore, when analyzing its behavior around sovereign default, the model successfully captures the declines in output, consumption and investment that are actually associated with these episodes.

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    File URL: http://www.banxico.org.mx/publicaciones-y-discursos/publicaciones/documentos-de-investigacion/banxico/%7B06F111E2-1FDC-1B72-D19B-C120BBBFAE5F%7D.pdf
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    Bibliographic Info

    Paper provided by Banco de México in its series Working Papers with number 2012-16.

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    Date of creation: Dec 2012
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    Handle: RePEc:bdm:wpaper:2012-16

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    Web page: http://www.banxico.org.mx
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    Keywords: Sovereign debt; sovereign default; business cycles; small open economy.;

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    1. Neumeyer, Pablo A. & Perri, Fabrizio, 2005. "Business cycles in emerging economies: the role of interest rates," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 345-380, March.
    2. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
    3. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
    4. Cuadra, Gabriel & Sapriza, Horacio, 2008. "Sovereign default, interest rates and political uncertainty in emerging markets," Journal of International Economics, Elsevier, vol. 76(1), pages 78-88, September.
    5. Michael Tomz & Mark L. J. Wright, 2007. "Do countries default in “bad times”?," Working Paper Series 2007-17, Federal Reserve Bank of San Francisco.
    6. Vivian Z. Yue & Enrique G. Mendoza, 2011. "A General Equilibrium Model of Sovereign Default and Business Cycles," IMF Working Papers 11/166, International Monetary Fund.
    7. Carmen M. Reinhart & Kenneth S. Rogoff, 2011. "From Financial Crash to Debt Crisis," American Economic Review, American Economic Association, vol. 101(5), pages 1676-1706, August.
    8. Patrick J. Kehoe & Fabrizio Perri, 2000. "International Business Cycles with Endogenous Incomplete Markets," NBER Working Papers 7870, National Bureau of Economic Research, Inc.
    9. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
    10. Cristina Arellano & Ananth Ramanarayanan, 2008. "Default and the maturity structure in sovereign bonds," Staff Report 410, Federal Reserve Bank of Minneapolis.
    11. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods matter," Working Paper 10-04, Federal Reserve Bank of Richmond.
    12. Uribe, Martin & Yue, Vivian Z., 2006. "Country spreads and emerging countries: Who drives whom?," Journal of International Economics, Elsevier, vol. 69(1), pages 6-36, June.
    13. Gaston Gelos & Guido Sandleris & Ratna Sahay, 2004. "Sovereign Borrowing by Developing Countries," IMF Working Papers 04/221, International Monetary Fund.
    14. Ugo Panizza & Eduardo Levy Yeyati, 2006. "The Elusive Costs of Sovereign Defaults," IDB Publications 6713, Inter-American Development Bank.
    15. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
    16. Yan Bai & Jing Zhang, 2006. "Financial Integration and International Risk Sharing," 2006 Meeting Papers 371, Society for Economic Dynamics.
    17. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
    18. Leonardo Martinez & Horacio Sapriza & Juan Carlos Hatchondo, 2010. "Quantitative Properties of Sovereign Default Models," IMF Working Papers 10/100, International Monetary Fund.
    19. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
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