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A Solution to the Disconnect between Country Risk and Business Cycle Theories

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  • Enrique G. Mendoza
  • Vivian Z. Yue

Abstract

We propose a model that solves the crucial disconnect between business cycle models that treat default risk as an exogenous interest rate on working capital, and sovereign default models that treat output fluctuations as an exogenous process with ad-hoc default costs. The model explains observed output dynamics around defaults, countercyclical spreads, high debt ratios, and key business cycle moments. Three features of the model are central for these results: working capital loans pay for imported inputs; default triggers an efficiency loss as imported inputs are replaced by imperfect domestic substitutes; and default on public and private foreign obligations occurs simultaneously.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13861.

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Date of creation: Mar 2008
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Handle: RePEc:nbr:nberwo:13861

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  1. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business cycles in emerging economies: the role of interest rates," Staff Report, Federal Reserve Bank of Minneapolis 335, Federal Reserve Bank of Minneapolis.
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  25. 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.
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