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Fear of Sovereign Default, Banks, and Expectations-Driven Business Cycles

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Abstract

What is the effect of the fear of future sovereign default on the economy of the defaulting country? The typical sovereign default model does not address this question. In this paper we wish to explore the possibility that changing expectations about future default themselves can lead to financial stress (as measured by credit spreads) and recessionary outcomes. We exploit the \news-shock" framework to consider an environment in which sovereign debt-holders receive imperfect signals about the portion of debt that a sovereign may default on in the future. We then investigate how domestic banks can play a role in transmitting the expectation of default into a realized recession through the interaction of the domestic banks' holdings of government debt and their risk-weighted capital requirements. Our results suggest that, consistent with the data, even in the absence of actual realized government default, an increase in pessimism regarding the prospect of future default results in a rise in yields on government debt and an increase in interest rates on private domestic loans, as well as a recession in the economy.

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Bibliographic Info

Paper provided by Carleton University, Department of Economics in its series Carleton Economic Papers with number 13-03.

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Length: 32 pages
Date of creation: May 2013
Date of revision:
Publication status: Published: Carleton Economic Papers
Handle: RePEc:car:carecp:13-03

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Keywords: expectations-driven business cycles; sovereign defaults; financial intermediation; news shocks; business cycles; interest rate spreads; capital adequacy requirements.;

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References

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  1. Silvio Contessi, 2012. "An application of conventional sovereign debt sustainability analysis to the current debt crises," Review, Federal Reserve Bank of St. Louis, issue May, pages 197-220.
  2. Alok Johri & Christopher Gunn, 2009. "News and knowledge capital," 2009 Meeting Papers 763, Society for Economic Dynamics.
  3. Ricardo Nunes & Horacio Sapriza & Ceyhun Bora Durdu, 2010. "News and sovereign default risk in small open economies," 2010 Meeting Papers 1224, Society for Economic Dynamics.
  4. Enrique G. Mendoza & Vincenzo Quadrini, 2009. "Financial Globalization, Financial Crises and Contagion," NBER Working Papers 15432, National Bureau of Economic Research, Inc.
  5. Matteo Iacoviello, 2010. "Financial Business Cycles," 2010 Meeting Papers 1053, Society for Economic Dynamics.
  6. Christopher M. Gunn & Alok Johri, 2011. "News, Intermediation Efficiency and Expectations-driven Boom-bust Cycles," Department of Economics Working Papers 2011-02, McMaster University.
  7. 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.
  8. Vivian Z. Yue, 2005. "Sovereign Default and Debt Renegotiation," 2005 Meeting Papers 138, Society for Economic Dynamics.
  9. Kollmann, Robert, 2012. "Global Banks, Financial Shocks and International Business Cycles: Evidence from an Estimated Model," CEPR Discussion Papers 8985, C.E.P.R. Discussion Papers.
  10. Luca Guerrieri & Matteo Iacoviello & Raoul Minetti, 2012. "Banks, Sovereign Debt and the International Transmission of Business Cycles," NBER Chapters, in: NBER International Seminar on Macroeconomics 2012, pages 181-213 National Bureau of Economic Research, Inc.
  11. Cesar Sosa-Padilla, 2012. "Sovereign Defaults and Banking Crises," Department of Economics Working Papers 2012-09, McMaster University.
  12. Beaudry, Paul & Portier, Franck, 2001. "An Exploration into Pigou's Theory of Cycles," CEPR Discussion Papers 2996, C.E.P.R. Discussion Papers.
  13. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
  14. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  15. Nir Jaimovich & Sergio Rebelo, 2007. "News and Business Cycles in Open Economies," Discussion Papers 07-016, Stanford Institute for Economic Policy Research.
  16. King, Robert G. & Plosser, Charles I. & Rebelo, Sergio T., 1988. "Production, growth and business cycles : I. The basic neoclassical model," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 195-232.
  17. Robert KOLLMANN, 2011. "Global Banking and International Business Cycles," 2011 Meeting Papers 20, Society for Economic Dynamics.
  18. Paul Beaudry & Martial Dupaigne & Franck Portier, 2011. "Modeling News-Driven International Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(1), pages 72-91, January.
  19. Christiano, Lawrence & Ilut, Cosmin & Motto, Roberto & Rostagno, Massimo, 2008. "Monetary policy and stock market boom-bust cycles," Working Paper Series 0955, European Central Bank.
  20. Eric Leeper & Todd Walker, 2011. "Information Flows and News Driven Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(1), pages 55-71, January.
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Cited by:
  1. Bergin, Adele & Conefrey, Thomas & FitzGerald, John & Kearney, Ide & Znuderl, Nusa, 2013. "The HERMES-13 macroeconomic model of the Irish economy," Papers WP460, Economic and Social Research Institute (ESRI).
  2. Paul Beaudry & Franck Portier, 2013. "News Driven Business Cycles: Insights and Challenges," NBER Working Papers 19411, National Bureau of Economic Research, Inc.

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