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Default risk and economic activity: A small open economy model with sovereign debt and default

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  • Jessica Roldan-Pena

    (University of California, Los Angeles)

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    Abstract

    Empirical evidence shows that sovereign defaults are associated with significant declines in economic activity in defaulting countries. However, the existing literature on sovereign debt and default mainly analyzes endowment economies and, therefore, does not speak for the interaction between default risk and macroeconomic dynamics. This paper develops a small open economy model with financial frictions, within which output and default risk are jointly determined, that allows to simultaneously examine the behavior of output, consumption and investment and their interaction with sovereign debt and 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, the countercyclicality of sovereign spreads and the negative correlation between investment and net exports observed in the data. Furthermore, when analyzing its dynamics around default episodes, the model captures the declines in output, consumption and investment that accompany sovereign defaults.

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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 735.

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    Date of creation: 2011
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    Handle: RePEc:red:sed011:735

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    1. Gelos, R. Gaston & Sahay, Ratna & Sandleris, Guido, 2011. "Sovereign borrowing by developing countries: What determines market access?," Journal of International Economics, Elsevier, Elsevier, vol. 83(2), pages 243-254, March.
    2. repec:acb:camaaa:2009-15 is not listed on IDEAS
    3. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Interest Rates and Political Uncertainty in Emerging Markets," Working Papers, Banco de México 2006-02, Banco de México.
    4. Kehoe, Timothy J & Levine, David K, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 60(4), pages 865-88, October.
    5. Ananth Ramanarayanan & Cristina Arellano, 2008. "Default and the Maturity Structure in Sovereign Bonds," 2008 Meeting Papers 479, Society for Economic Dynamics.
    6. Michael Tomz & Mark L. J. Wright, 2007. "Do Countries Default in "Bad Times" ?," Journal of the European Economic Association, MIT Press, MIT Press, vol. 5(2-3), pages 352-360, 04-05.
    7. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    8. 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.
    9. Leonardo Martinez & Horacio Sapriza & Juan Carlos Hatchondo, 2010. "Quantitative Properties of Sovereign Default Models," IMF Working Papers 10/100, International Monetary Fund.
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