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Default Risk and Economic Activity: A Small Open Economy Model with Sovereign Debt and Default

  • Jessica Roldán-Peña
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    Empirical evidence shows that sovereign defaults are associated with significant downturns in economic activity in defaulting countries. However, the existing literature on sovereign debt and default mainly analyzes endowment economies and, therefore, does not address the relationship between default risk and macroeconomic dynamics. This paper develops a general equilibrium small open economy model with financial frictions that allows to simultaneously examine the behavior of output, investment and borrowing dynamics and its interaction with sovereign default. When calibrated to match the business cycles properties of an average emerging market economy, the model is able to reproduce the countercyclicality of net exports and sovereign spreads and the negative correlation between investment and net exports observed in the data. Furthermore, when analyzing its behavior around sovereign default, the model successfully captures the declines in output, consumption and investment that are actually associated with these episodes.

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    File URL: http://www.banxico.org.mx/publicaciones-y-discursos/publicaciones/documentos-de-investigacion/banxico/%7B06F111E2-1FDC-1B72-D19B-C120BBBFAE5F%7D.pdf
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    Paper provided by Banco de México in its series Working Papers with number 2012-16.

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    Date of creation: Dec 2012
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    Handle: RePEc:bdm:wpaper:2012-16
    Contact details of provider: Web page: http://www.banxico.org.mx

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    1. Gelos, R. Gaston & Sahay, Ratna & Sandleris, Guido, 2011. "Sovereign borrowing by developing countries: What determines market access?," Journal of International Economics, Elsevier, vol. 83(2), pages 243-254, March.
    2. Yan Bai & Jing Zhang, 2009. "Financial Integration and International Risk Sharing," Working Papers 594, Research Seminar in International Economics, University of Michigan.
    3. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
    4. Enrique G. Mendoza & Vivian Z. Yue, 2012. "A General Equilibrium Model of Sovereign Default and Business Cycles," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 889-946.
    5. Carmen M. Reinhart & Kenneth S. Rogoff, 2011. "From Financial Crash to Debt Crisis," American Economic Review, American Economic Association, vol. 101(5), pages 1676-1706, August.
    6. Cristina Arellano & Ananth Ramanarayanan, 2012. "Default and the Maturity Structure in Sovereign Bonds," Journal of Political Economy, University of Chicago Press, vol. 120(2), pages 187 - 232.
    7. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," NBER Working Papers 10387, National Bureau of Economic Research, Inc.
    8. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
    9. Michael Tomz & Mark L. J. Wright, 2007. "Do Countries Default in "Bad Times" ?," Journal of the European Economic Association, MIT Press, vol. 5(2-3), pages 352-360, 04-05.
    10. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
    11. Yeyati, Eduardo Levy & Panizza, Ugo, 2011. "The elusive costs of sovereign defaults," Journal of Development Economics, Elsevier, vol. 94(1), pages 95-105, January.
    12. Patrick J. Kehoe & Fabrizio Perri, 2000. "International Business Cycles with Endogenous Incomplete Markets," NBER Working Papers 7870, National Bureau of Economic Research, Inc.
    13. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods matter," Working Paper 10-04, Federal Reserve Bank of Richmond.
    14. Martin Uribe & Vivian Z. Yue, 2003. "Country Spreads and Emerging Countries: Who Drives Whom?," NBER Working Papers 10018, National Bureau of Economic Research, Inc.
    15. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
    16. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Interest Rates and Political Uncertainty in Emerging Markets," Working Papers 2006-02, Banco de México.
    17. 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.
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