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Optimal Sovereign Debt Default

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  • Michael Grill

    (Deutsche Bundesbank)

  • Klaus Adam

    (Mannheim University)

Abstract

We determine optimal government default policies for a small open economy in which a domestic government can borrow internationally by issuing non-contingent debt contracts. Unlike earlier work, we consider optimal default policies under full government commitment and treat repayment of international debt as a decision variable. Default can be optimal under commitment because it allows for increased international diversiÃÂcation of domestic output and consumption risk when government bond markets are incomplete. In the absence of default costs, default optimally occurs very frequently and independently of the country's net foreign asset position. Optimal default policies, however, change drastically when a government default entails small but positive dead weight costs: default is then optimal only in response to disaster-like shocks to domestic output, or when a small adverse shock pushes international debt levels sufficiently close to the country's borrowing limit. Optimal default policies increase welfare signiÃÂcantly compared to a situation where default is ruled out by assumption, even for sizable default costs. For sufficiently low level of default costs the optimal default policies can approximately be replicated by issuing a simple equity-like government bond.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 882.

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Date of creation: 2012
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Handle: RePEc:red:sed012:882

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  1. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Proceedings, Federal Reserve Bank of Cleveland, pages 519-546.
  2. Grossman, Herschel I & Van Huyck, John B, 1988. "Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation," American Economic Review, American Economic Association, vol. 78(5), pages 1088-97, December.
  3. Christopher A. Sims, 2001. "Fiscal consequences for Mexico of adopting the dollar," Proceedings, Federal Reserve Bank of Cleveland, pages 597-625.
  4. Juan J. Cruces & Christoph Trebesch, 2013. "Sovereign Defaults: The Price of Haircuts," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 85-117, July.
  5. William R. Zame, 1992. "Efficiency and the Role of Default When Security Markets are Incomplete," UCLA Economics Working Papers 673, UCLA Department of Economics.
  6. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  7. Ugo Panizza & Federico Sturzenegger & Jeromin Zettelmeyer, 2009. "The Economics and Law of Sovereign Debt and Default," Journal of Economic Literature, American Economic Association, vol. 47(3), pages 651-98, September.
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Cited by:
  1. Falko Juessen & Andreas Schabert, 2013. "Fiscal Policy, Sovereign Default, and Bailouts," Working Paper Series in Economics 67, University of Cologne, Department of Economics.

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