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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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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.98.3.690
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File URL: http://www.aeaweb.org/aer/data/june08/20050350_data.zip
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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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  10. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
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  19. Harold L. Cole & Patrick J. Kehoe, 1997. "Reviving reputation models of international debt," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 21-30.
  20. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  21. Cristina Arellano & Ananth Ramanarayanan, 2006. "Default and the Term Structure in Sovereign Bonds," 2006 Meeting Papers 299, Society for Economic Dynamics.
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  24. William R. Zame, 1990. "Efficiency and the Role of Default When Security Markets are Incomplete," UCLA Economics Working Papers 585, UCLA Department of Economics.
  25. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  26. Guido M. Sandleris, 2005. "Sovereign Defaults: Information, Investment and Credit," 2005 Meeting Papers 21, Society for Economic Dynamics.
  27. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
  28. Manuel Amador, 2004. "A Political Model Sovereign Debt Repayment," 2004 Meeting Papers 762, Society for Economic Dynamics.
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