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On the cyclicality of the interest rate in emerging economy models: solution methods matter

  • Juan Carlos Hatchondo
  • Leonardo Martinez
  • Horacio Sapriza

We study the sovereign default model that has been used to account for the cyclical behavior of interest rates in emerging market economies. This model is often solved using the discrete state space technique with evenly spaced grid points. We show that this method necessitates a large number of grid points to avoid generating spurious interest rate movements. This makes the discrete state technique significantly more inefficient than using Chebyshev polynomials or cubic spline interpolation to approximate the value functions. We show that the inefficiency of the discrete state space technique is more severe for parameterizations such that the borrowing levels that are observed more frequently in the simulations feature a high sensitivity of the bond price to the borrowing level. In addition, we find that the efficiency of the discrete state space technique can be greatly improved by (i) finding the equilibrium as the limit of the equilibrium of the finite-horizon version of the model, instead of iterating separately on the value and bond price functions and (ii) concentrating grid points in asset levels at which the bond price is more sensitive to the borrowing level and in levels that are observed more often in the model simulations. Our analysis is also relevant for the study of other credit markets. ; Replaces Working Paper 06-11 (Computing Business Cycles in Emerging Economy Models) ; Updated by Working Paper 10-04 (Quantitative Properties of Sovereign Default Models: Solution Methods Matter)

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Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 09-13.

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Date of creation: 2009
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Handle: RePEc:fip:fedrwp:09-13
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  1. Mark Aguiar & Gita Gopinath, 2004. "Emerging Market Business Cycles: The Cycle is the Trend," NBER Working Papers 10734, National Bureau of Economic Research, Inc.
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  3. Cuadra, Gabriel & Sapriza, Horacio, 2008. "Sovereign default, interest rates and political uncertainty in emerging markets," Journal of International Economics, Elsevier, vol. 76(1), pages 78-88, September.
  4. Martin Uribe & Vivian Z. Yue, 2003. "Country Spreads and Emerging Countries: Who Drives Whom?," NBER Working Papers 10018, National Bureau of Economic Research, Inc.
  5. Gabriel Cuadra & Juan M. Sanchez & Horacio Sapriza, 2009. "Fiscal policy and default risk in emerging markets," Working Paper 09-01, Federal Reserve Bank of Richmond.
  6. Ananth Ramanarayanan & Cristina Arellano, 2008. "Default and the Maturity Structure in Sovereign Bonds," 2008 Meeting Papers 479, Society for Economic Dynamics.
  7. Igor Livshits & James MacGee & Michele Tertilt, 2005. "Consumer Bankruptcy: A Fresh Start," Discussion Papers 04-011, Stanford Institute for Economic Policy Research.
  8. Aguiar, Mark & Gopinath, Gita, 2007. "Emerging Market Business Cycles: The Cycle is the Trend," Scholarly Articles 11988098, Harvard University Department of Economics.
  9. David Benjamin & Mark L. J. Wright, 2009. "Recovery Before Redemption: A Theory Of Delays In Sovereign Debt Renegotiations," CAMA Working Papers 2009-15, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  10. Neumeyer, Pablo A. & Perri, Fabrizio, 2005. "Business cycles in emerging economies: the role of interest rates," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 345-380, March.
  11. Sangeeta Pratap & Carlos Urrutia, 2010. "Financial Frictions and Total Factor Productivity: Accounting for the Real Effects of Financial Crises," Economics Working Paper Archive at Hunter College 429, Hunter College Department of Economics.
  12. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany.
  13. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Terms of Trade and Interest Rates in Emerging Markets," Working Papers 2006-01, Banco de México.
  14. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & Jose-Victor Rios-Rull, 2002. "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default," Centro de Alti­simos Estudios Ri­os Pe©rez(CAERP) 2, Centro de Altisimos Estudios Rios Perez (CAERP).
  15. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
  16. Felipe Meza & David Benjamin, 2007. "Total Factor Productivity and Labor Reallocation: The Case of the Korean 1997 Crisis," 2007 Meeting Papers 157, Society for Economic Dynamics.
  17. Kartik Athreya & Xuan S. Tam & Eric R. Young, 2012. "A Quantitative Theory of Information and Unsecured Credit," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(3), pages 153-83, July.
  18. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2007. "Quantitative models of sovereign default and the threat of financial exclusion," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 251-286.
  19. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2008. "Heterogeneous borrowers in quantitative models of sovereign default," Working Paper 07-01, Federal Reserve Bank of Richmond.
  20. Boz, Emine, 2011. "Sovereign default, private sector creditors, and the IFIs," Journal of International Economics, Elsevier, vol. 83(1), pages 70-82, January.
  21. Aguiar, Mark & Gopinath, Gita, 2006. "Defaultable debt, interest rates and the current account," Journal of International Economics, Elsevier, vol. 69(1), pages 64-83, June.
  22. Athreya, Kartik B., 2002. "Welfare implications of the Bankruptcy Reform Act of 1999," Journal of Monetary Economics, Elsevier, vol. 49(8), pages 1567-1595, November.
  23. Emine Boz & Christian Daude & C. Bora Durdu, 2011. "Emerging Market Business Cycles Revisited: Learning about the Trend," Koç University-TUSIAD Economic Research Forum Working Papers 1110, Koc University-TUSIAD Economic Research Forum.
  24. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
  25. Li, Wenli & Sarte, Pierre-Daniel, 2006. "U.S. consumer bankruptcy choice: The importance of general equilibrium effects," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 613-631, April.
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