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Optimal external debt and default

  • Guimarães, Bernardo

This paper analyses whether sovereign default episodes can be seen as contingencies of optimal international lending contracts. The model considers a small open economy with capital accumulation and without commitment to repay debt. Taking first order approximations of Bellman equations, I derive analytical expressions for the equilibrium level of debt and the optimal debt contract. In this environment, debt relief generated by reasonable fluctuations in productivity is an order of magnitude below that generated by shocks to world interest rates. Debt relief prescribed by the model following the interest rate hikes of 1980-81 accounts for a substantial part of the debt forgiveness obtained by the main Latin American countries through the Brady agreements.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6035.

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Date of creation: Jan 2007
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Handle: RePEc:cpr:ceprdp:6035
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  1. Krugman, Paul, 1988. "Financing vs. forgiving a debt overhang," Journal of Development Economics, Elsevier, vol. 29(3), pages 253-268, November.
  2. Pierre-Olivier Gourinchas & Olivier Jeanne, 2006. "The Elusive Gains from International Financial Integration," Review of Economic Studies, Oxford University Press, vol. 73(3), pages 715-741.
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  4. Natalia Kovrijnykh & Balázs Szentes, 2007. "Equilibrium Default Cycles," Journal of Political Economy, University of Chicago Press, vol. 115, pages 403-446.
  5. Reinhart, Carmen & Rogoff, Kenneth, 2004. "Serial default and the “paradox” of rich to poor capital flows," MPRA Paper 13997, University Library of Munich, Germany.
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  23. Albert Marcet & Ramon Marimon, 1992. "Communication, commitment, and growth," Discussion Paper / Institute for Empirical Macroeconomics 74, Federal Reserve Bank of Minneapolis.
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