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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. repec:acb:camaaa:2009-15 is not listed on IDEAS
    2. Michael Tomz & Mark L. J. Wright, 2007. "Do countries default in “bad times”?," Working Paper Series 2007-17, Federal Reserve Bank of San Francisco.
    3. Kehoe, Timothy J & Levine, David K, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Wiley Blackwell, vol. 60(4), pages 865-88, October.
    4. R. Gaston Gelos, Ratna Sahay and Guido Sandleris, 2008. "Sovereign Borrowing by Developing Countries: What Determines Market Access?," Business School Working Papers 2008-02, Universidad Torcuato Di Tella.
    5. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    6. Cuadra, Gabriel & Sapriza, Horacio, 2008. "Sovereign default, interest rates and political uncertainty in emerging markets," Journal of International Economics, Elsevier, vol. 76(1), pages 78-88, September.
    7. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
    8. Cristina Arellano & Ananth Ramanarayanan, 2012. "Default and the Maturity Structure in Sovereign Bonds," Journal of Political Economy, University of Chicago Press, vol. 120(2), pages 187 - 232.
    9. Leonardo Martinez & Horacio Sapriza & Juan Carlos Hatchondo, 2010. "Quantitative Properties of Sovereign Default Models: Solution Methods Matter," IMF Working Papers 10/100, International Monetary Fund.
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