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

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  • Christopher M. Gunn
  • Alok Johri

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 McMaster University in its series Department of Economics Working Papers with number 2013-08.

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Length: 32 pages
Date of creation: Jun 2013
Date of revision:
Handle: RePEc:mcm:deptwp:2013-08

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

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  1. Beaudry, Paul & Dupaigne, Martial & Portier, Franck, 2009. "Modeling News-Driven International Business Cycles," TSE Working Papers, Toulouse School of Economics (TSE) 09-117, Toulouse School of Economics (TSE).
  2. Christopher M. Gunn & Alok Johri, 2009. "News and knowledge capital," Department of Economics Working Papers 2009-02, McMaster University.
  3. Nir Jaimovich & Sergio Rebelo, 2007. "News and Business Cycles in Open Economies," Discussion Papers, Stanford Institute for Economic Policy Research 07-016, Stanford Institute for Economic Policy Research.
  4. Enrique G. Mendoza & Vincenzo Quadrini, 2009. "Financial Globalization, Financial Crises and Contagion," NBER Working Papers 15432, National Bureau of Economic Research, Inc.
  5. 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.
  6. Ricardo Nunes & Horacio Sapriza & Ceyhun Bora Durdu, 2010. "News and sovereign default risk in small open economies," 2010 Meeting Papers, Society for Economic Dynamics 1224, Society for Economic Dynamics.
  7. Neumeyer, Pablo Andrés & Perri, Fabrizio, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4482, C.E.P.R. Discussion Papers.
  8. Yue, Vivian Z., 2010. "Sovereign default and debt renegotiation," Journal of International Economics, Elsevier, Elsevier, vol. 80(2), pages 176-187, March.
  9. Robert Kollmann, 2013. "Global Banks, Financial Shocks, and International Business Cycles: Evidence from an Estimated Model," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 45(s2), pages 159-195, December.
  10. Cesar Sosa-Padilla, 2012. "Sovereign Defaults and Banking Crises," Department of Economics Working Papers 2012-09, McMaster University.
  11. Kollmann, Robert & Enders, Zeno & Müller, Gernot J., 2011. "Global banking and international business cycles," European Economic Review, Elsevier, Elsevier, vol. 55(3), pages 407-426, April.
  12. Luca Guerrieri & Matteo Iacoviello & Raoul Minetti, 2013. "Banks, Sovereign Debt, and the International Transmission of Business Cycles," NBER International Seminar on Macroeconomics, University of Chicago Press, University of Chicago Press, vol. 9(1), pages 181 - 213.
  13. 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, Elsevier, vol. 21(2-3), pages 195-232.
  14. 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.
  15. Christopher M. Gunn & Alok Johri, 2011. "News, Intermediation Efficiency and Expectations-driven Boom-bust Cycles," Department of Economics Working Papers 2011-02, McMaster University.
  16. Matteo Iacoviello, 2010. "Financial Business Cycles," 2010 Meeting Papers, Society for Economic Dynamics 1053, Society for Economic Dynamics.
  17. Silvio Contessi, 2012. "An application of conventional sovereign debt sustainability analysis to the current debt crises," Review, Federal Reserve Bank of St. Louis, Federal Reserve Bank of St. Louis, issue May, pages 197-220.
  18. 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.
  19. Beaudry, Paul & Portier, Franck, 2001. "An Exploration into Pigou's Theory of Cycles," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2996, C.E.P.R. Discussion Papers.
  20. Christiano, Lawrence & Ilut, Cosmin & Motto, Roberto & Rostagno, Massimo, 2008. "Monetary policy and stock market boom-bust cycles," Working Paper Series, European Central Bank 0955, European Central Bank.
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Cited by:
  1. Paul Beaudry & Franck Portier, 2014. "News Driven Business Cycles: Insights and Challenges," 2014 Meeting Papers, Society for Economic Dynamics 289, Society for Economic Dynamics.
  2. Bergin, Adele & Conefrey, Thomas & FitzGerald, John & Kearney, Ide & Znuderl, Nusa, 2013. "The HERMES-13 macroeconomic model of the Irish economy," Papers, Economic and Social Research Institute (ESRI) WP460, Economic and Social Research Institute (ESRI).

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