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Dynamics of investment, debt, and default

  • Grey Gordon
  • Pablo Guerrón-Quintana

How does physical capital accumulation affect the decision to default in developing small open economies? We find that, conditional on a level of foreign indebtedness, more capital improves the sovereign’s ability to meet its obligations, reducing the likelihood of default and the risk premium. This effect, however, is diminishing in the stock of capital because capital also tames the severity of the contraction following default, making autarky more appealing. Access to long-term debt and costly capital adjustment are crucial for matching business cycles. Our quantitative model delivers default episodes that mimic those observed in the data.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 13-18.

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Date of creation: 2013
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Handle: RePEc:fip:fedpwp:13-18
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