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Default Risk and Income Fluctuations in Emerging Economies

  • Cristina Arellano

Recent sovereign defaults are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default is more likely in recessions because this is when it is more costly for a risk averse borrower to repay noncontingent debt. The model closely matches business cycles in Argentina predicting high volatility of interest rates, higher volatility of consumption relative to output, and negative correlations of output with interest rates and the trade balance.

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 98 (2008)
Issue (Month): 3 (June)
Pages: 690-712

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Handle: RePEc:aea:aecrev:v:98:y:2008:i:3:p:690-712
Note: DOI: 10.1257/aer.98.3.690
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