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A Model of the Twin Ds: Optimal Default and Devaluation

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  • Uribe, Martín
  • Schmitt-Grohé, Stephanie
  • Yue, Vivian
  • Na, Seunghoon

Abstract

This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. By contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have stronger default incentives and therefore support less external debt than economies with optimally floating rates.

Suggested Citation

  • Uribe, Martín & Schmitt-Grohé, Stephanie & Yue, Vivian & Na, Seunghoon, 2015. "A Model of the Twin Ds: Optimal Default and Devaluation," CEPR Discussion Papers 10697, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:10697
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    1. A Model of the Twin Ds: Optimal Default and Devaluation
      by Christian Zimmermann in NEP-DGE blog on 2015-09-11 19:44:53

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    Cited by:

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    2. Neele Balke, 2018. "The Employment Cost of Sovereign Default," 2018 Meeting Papers 1256, Society for Economic Dynamics.
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    More about this item

    Keywords

    Sovereign default; Exchange rates; Optimal monetary policy; Capital controls; Currency pegs; Downward nominal wage rigidity;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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