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Default risk, sectoral reallocation, and persistent recessions

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  • Arellano, Cristina
  • Bai, Yan
  • Mihalache, Gabriel

Abstract

Sovereign debt crises are associated with large and persistent declines in economic activity, disproportionately so for nontradable sectors. This paper documents this pattern using Spanish data and builds a two-sector, dynamic quantitative model of sovereign default with capital accumulation. Recessions are very persistent in the model and more pronounced for nontraded sectors because of default risk. An adverse domestic shock increases the likelihood of default, limits capital inflows, and thus restricts the ability of the economy to exploit investment opportunities. The economy responds by reducing investment and reallocating capital toward the traded sector to support debt service payments. The real exchange rate depreciates, a reflection of the scarcity of traded goods. We find that these mechanisms are quantitatively important for rationalizing the experience of Spain during the recent debt crisis.

Suggested Citation

  • Arellano, Cristina & Bai, Yan & Mihalache, Gabriel, 2018. "Default risk, sectoral reallocation, and persistent recessions," Journal of International Economics, Elsevier, vol. 112(C), pages 182-199.
  • Handle: RePEc:eee:inecon:v:112:y:2018:i:c:p:182-199
    DOI: 10.1016/j.jinteco.2018.01.004
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    Cited by:

    1. Keiichiro Kobayashi & Kozo Ueda, 2017. "Secular Stagnation and Low Interest Rates under the Fear of a Government Debt Crisis," CIGS Working Paper Series 17-012E, The Canon Institute for Global Studies.
    2. Sophie Piton, 2018. "Do Unit Labor Costs Matter? A Decomposition Exercise on European Data," PSE Working Papers halshs-01785345, HAL.
    3. Sophie Piton, 2017. "Economic Integration and the Non-tradable Sector: The European Experience," 2017 Papers ppi361, Job Market Papers.
    4. Sophie Piton, 2018. "Do Unit Labor Costs Matter? A Decomposition Exercise on European Data," Working Papers 2018-07, CEPII research center.

    More about this item

    Keywords

    European debt crisis; Traded and nontraded production; Real exchange rate; Capital accumulation; Sovereign default with production economy;

    JEL classification:

    • F3 - International Economics - - International Finance
    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles

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