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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. 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.
    2. Martin Uribe & Vivian Z. Yue, 2003. "Country Spreads and Emerging Countries: Who Drives Whom?," NBER Working Papers 10018, National Bureau of Economic Research, Inc.
    3. Cristina Arellano & Ananth Ramanarayanan, 2008. "Default and the maturity structure in sovereign bonds," Globalization and Monetary Policy Institute Working Paper 19, Federal Reserve Bank of Dallas.
    4. Yan Bai & Jing Zhang, 2009. "Financial Integration and International Risk Sharing," Working Papers 594, Research Seminar in International Economics, University of Michigan.
    5. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Interest Rates and Political Uncertainty in Emerging Markets," Working Papers 2006-02, Banco de México.
    6. Patrick J. Kehoe & Fabrizio Perri, 2000. "International business cycles with endogenous incomplete markets," Staff Report 265, Federal Reserve Bank of Minneapolis.
    7. Neumeyer, Pablo Andrés & Perri, Fabrizio, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," CEPR Discussion Papers 4482, C.E.P.R. Discussion Papers.
    8. Michael Tomz & Mark L. J. Wright, 2007. "Do Countries Default In "Bad Times"?," CAMA Working Papers 2007-23, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    9. Ugo Panizza & Eduardo Levy Yeyati, 2006. "The Elusive Costs of Sovereign Defaults," Research Department Publications 4485, Inter-American Development Bank, Research Department.
    10. R. Gaston Gelos, Ratna Sahay and Guido Sandleris, 2008. "Sovereign Borrowing by Developing Countries: What Determines Market Access?," Business School Working Papers 2008-02, Universidad Torcuato Di Tella.
    11. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
    12. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
    13. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
    14. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    15. Leonardo Martinez & Horacio Sapriza & Juan Carlos Hatchondo, 2010. "Quantitative Properties of Sovereign Default Models; Solution Methods Matter," IMF Working Papers 10/100, International Monetary Fund.
    16. 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.
    17. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
    18. 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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