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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. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Jun.
    2. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Interest Rates and Political Uncertainty in Emerging Markets," Working Papers, Banco de México 2006-02, Banco de México.
    3. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper, Federal Reserve Bank of Richmond 08-02, Federal Reserve Bank of Richmond.
    4. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers, Federal Reserve Bank of Boston 04-5, Federal Reserve Bank of Boston.
    5. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers, Federal Reserve Bank of Minneapolis 445, Federal Reserve Bank of Minneapolis.
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    7. Gaston Gelos & Guido Sandleris & Ratna Sahay, 2004. "Sovereign Borrowing by Developing Countries," IMF Working Papers 04/221, International Monetary Fund.
    8. Yeyati, Eduardo Levy & Panizza, Ugo, 2011. "The elusive costs of sovereign defaults," Journal of Development Economics, Elsevier, Elsevier, vol. 94(1), pages 95-105, January.
    9. Leonardo Martinez & Horacio Sapriza & Juan Carlos Hatchondo, 2010. "Quantitative Properties of Sovereign Default Models," IMF Working Papers 10/100, International Monetary Fund.
    10. Patrick J. Kehoe & Fabrizio Perri, 2002. "International Business Cycles with Endogenous Incomplete Markets," Econometrica, Econometric Society, Econometric Society, vol. 70(3), pages 907-928, May.
    11. Bai, Yan & Zhang, Jing, 2012. "Financial integration and international risk sharing," Journal of International Economics, Elsevier, Elsevier, vol. 86(1), pages 17-32.
    12. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," NBER Working Papers 10387, National Bureau of Economic Research, Inc.
    13. Carmen M. Reinhart & Kenneth S. Rogoff, 2011. "From Financial Crash to Debt Crisis," American Economic Review, American Economic Association, American Economic Association, vol. 101(5), pages 1676-1706, August.
    14. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    15. Michael Tomz & Mark L. J. Wright, 2007. "Do countries default in “bad times”?," Working Paper Series, Federal Reserve Bank of San Francisco 2007-17, Federal Reserve Bank of San Francisco.
    16. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods matter," Working Paper, Federal Reserve Bank of Richmond 10-04, Federal Reserve Bank of Richmond.
    17. Enrique G. Mendoza & Vivian Z. Yue, 2012. "A General Equilibrium Model of Sovereign Default and Business Cycles," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 889-946.
    18. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, American Economic Association, vol. 81(4), pages 797-818, September.
    19. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 48(2), pages 289-309, April.
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