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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. Pablo Andres Neumeyer & Fabrizio Perri, 1999. "Business Cycles in Emerging Economies: the role of interest rates," Department of Economics Working Papers 014, Universidad Torcuato Di Tella.
    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. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates and the current account," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
    4. Patrick J. Kehoe & Fabrizio Perri, 2000. "International business cycles with endogenous incomplete markets," Staff Report 265, Federal Reserve Bank of Minneapolis.
    5. Carmen M. Reinhart & Kenneth S. Rogoff, 2010. "From Financial Crash to Debt Crisis," NBER Working Papers 15795, National Bureau of Economic Research, Inc.
    6. Gaston Gelos & Guido Sandleris & Ratna Sahay, 2004. "Sovereign Borrowing by Developing Countries; What Determines Market Access?," IMF Working Papers 04/221, International Monetary Fund.
    7. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
    8. Michael Tomz & Mark L. J. Wright, 2007. "Do countries default in “bad times”?," Working Paper Series 2007-17, Federal Reserve Bank of San Francisco.
    9. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
    10. 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.
    11. Vivian Z. Yue & Enrique G. Mendoza, 2011. "A General Equilibrium Model of Sovereign Default and Business Cycles," IMF Working Papers 11/166, International Monetary Fund.
    12. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Interest Rates and Political Uncertainty in Emerging Markets," Working Papers 2006-02, Banco de México.
    13. Ugo Panizza & Eduardo Levy Yeyati, 2006. "The Elusive Costs of Sovereign Defaults," IDB Publications (Working Papers) 6713, Inter-American Development Bank.
    14. Cristina Arellano & Ananth Ramanarayanan, 2008. "Default and the maturity structure in sovereign bonds," Staff Report 410, Federal Reserve Bank of Minneapolis.
    15. Yan Bai & Jing Zhang, 2006. "Financial Integration and International Risk Sharing," 2006 Meeting Papers 371, Society for Economic Dynamics.
    16. 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.
    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. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
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