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Default and Interest Rate Shocks: Renegotiation Matters

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Listed:
  • Victor Almeida
  • Carlos Esquivel
  • Timothy J. Kehoe
  • Juan Pablo Nicolini

Abstract

We develop a sovereign default model with debt renegotiation in which interest-rate shocks affect default incentives through two mechanisms. Under the standard mechanism, higher interest rates tighten the government’s budget constraint. Under the renegotiation mechanism, higher rates increase lenders’ opportunity cost of holding delinquent debt, which makes lenders accept larger haircuts and makes default more attractive for the government. We argue that our novel renegotiation mechanism reconciles standard sovereign default models with the narrative that the sharp increase in the real interest rate in the United States was a relevant factor in the defaults of the early 1980s.

Suggested Citation

  • Victor Almeida & Carlos Esquivel & Timothy J. Kehoe & Juan Pablo Nicolini, 2025. "Default and Interest Rate Shocks: Renegotiation Matters," NBER Working Papers 34555, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:34555
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    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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