Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default
AbstractInternational historical records on public debt show infrequent episodes of outright default on domestic debt. Reinhart and Rogoff (2008) document these events and argue that they constitute a “forgotten history” in Macroeconomics. This paper develops a theory of domestic sovereign default in which distributional incentives, interacting with default costs, make default part of the optimal policy of a utilitarian social planner. The model supports equilibria with debt subject to default risk in which rising wealth inequality reduces the optimal debt and increases default probabilities and spreads. A quantitative experiment calibrated to European data shows that, in the observed range of inequality in the distribution of bond holdings, the model accounts for 1/3rd of the average debt and spreads of about 400 basis points. Default risk reduces sharply the sustainable debt, except when the weights in the government’s payoff function value the utility of bond holders more than their share of the wealth distribution. If the former is sufficiently larger than the latter, the model supports debt ratios similar to European averages exposed to low default probabilities.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19477.
Date of creation: Sep 2013
Date of revision:
Publication status: published as Pablo D’Erasmo, Enrique G. Mendoza. "Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default," in Sebnem Kalemli-Ozcan, Carmen Reinhart, and Kenneth Rogoff, organizers, "Sovereign Debt and Financial Crisis" (2014)
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Find related papers by JEL classification:
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
- H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-10-02 (All new papers)
- NEP-DGE-2013-10-02 (Dynamic General Equilibrium)
- NEP-MAC-2013-10-02 (Macroeconomics)
- NEP-OPM-2013-10-02 (Open Economy Macroeconomic)
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