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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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    Related research

    Keywords: Sovereign debt; sovereign default; business cycles; small open economy.;

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    1. Yeyati, Eduardo Levy & Panizza, Ugo, 2011. "The elusive costs of sovereign defaults," Journal of Development Economics, Elsevier, vol. 94(1), pages 95-105, January.
    2. Leonardo Martinez & Horacio Sapriza & Juan Carlos Hatchondo, 2010. "Quantitative Properties of Sovereign Default Models: Solution Methods Matter," IMF Working Papers 10/100, International Monetary Fund.
    3. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
    4. Cristina Arellano & Ananth Ramanarayanan, 2008. "Default and the maturity structure in sovereign bonds," Globalization and Monetary Policy Institute Working Paper 19, Federal Reserve Bank of Dallas.
    5. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
    6. Pablo A. Neumeyer & Fabrizio Perri, 2001. "Business Cycles in Emerging Economies:The Role of Interest Rates," Working Papers 01-12, New York University, Leonard N. Stern School of Business, Department of Economics.
    7. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
    8. 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.
    9. Patrick J. Kehoe & Fabrizio Perri, 2000. "International business cycles with endogenous incomplete markets," Staff Report 265, Federal Reserve Bank of Minneapolis.
    10. Bai, Yan & Zhang, Jing, 2012. "Financial integration and international risk sharing," Journal of International Economics, Elsevier, vol. 86(1), pages 17-32.
    11. 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.
    12. Michael Tomz & Mark L. J. Wright, 2007. "Do Countries Default in "Bad Times" ?," Journal of the European Economic Association, MIT Press, vol. 5(2-3), pages 352-360, 04-05.
    13. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    14. R. Gaston Gelos, Ratna Sahay and Guido Sandleris, 2008. "Sovereign Borrowing by Developing Countries: What Determines Market Access?," Business School Working Papers 2008-02, Universidad Torcuato Di Tella.
    15. 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.
    16. 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.
    17. Martin Uribe & Vivian Z. Yue, 2003. "Country Spreads and Emerging Countries: Who Drives Whom?," NBER Working Papers 10018, National Bureau of Economic Research, Inc.
    18. 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.
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