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The Effects of Higher Borrowing Costs: Insights from Sovereign Default Models

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  • Grey Gordon

Abstract

According to sovereign default models, debt becoming more expensive for a sovereign entity results in several significant effects. The government deleverages, capital investment falls for a prolonged duration, GDP and labor decline gradually with capital, and consumption can drop sharply. Outcomes are asymmetric, as positive shocks compress spreads slightly, but negative shocks can increase spreads substantially. The current account tends to increase due to reduced government borrowing from international lenders. The real exchange rate depreciates, which boosts net exports, but also tends to manifest empirically as currency depreciation and inflation. Failure to deleverage dampens short-term costs but creates a lasting drag on the economy.

Suggested Citation

  • Grey Gordon, 2023. "The Effects of Higher Borrowing Costs: Insights from Sovereign Default Models," Richmond Fed Economic Brief, Federal Reserve Bank of Richmond, vol. 23(22), July.
    • Handle: RePEc:fip:fedreb:96407
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