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Default risk and economic activity: A small open economy model with sovereign debt and default

  • Jessica Roldan-Pena

    (University of California, Los Angeles)

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    Empirical evidence shows that sovereign defaults are associated with significant declines in economic activity in defaulting countries. However, the existing literature on sovereign debt and default mainly analyzes endowment economies and, therefore, does not speak for the interaction between default risk and macroeconomic dynamics. This paper develops a small open economy model with financial frictions, within which output and default risk are jointly determined, that allows to simultaneously examine the behavior of output, consumption and investment and their interaction with sovereign debt and default. When calibrated to match the business cycles properties of an average emerging market economy, the model is able to reproduce the countercyclicality of net exports, the countercyclicality of sovereign spreads and the negative correlation between investment and net exports observed in the data. Furthermore, when analyzing its dynamics around default episodes, the model captures the declines in output, consumption and investment that accompany sovereign defaults.

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    File URL: https://www.economicdynamics.org/meetpapers/2011/paper_735.pdf
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    Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 735.

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    Date of creation: 2011
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    Handle: RePEc:red:sed011:735
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    1. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods matter," Working Paper 10-04, Federal Reserve Bank of Richmond.
    2. Michael Tomz & Mark L. J. Wright, 2007. "Do Countries Default in "Bad Times" ?," Journal of the European Economic Association, MIT Press, vol. 5(2-3), pages 352-360, 04-05.
    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. Kehoe, Timothy J & Levine, David K, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Wiley Blackwell, vol. 60(4), pages 865-88, October.
    5. Gaston Gelos & Guido Sandleris & Ratna Sahay, 2004. "Sovereign Borrowing by Developing Countries; What Determines Market Access?," IMF Working Papers 04/221, International Monetary Fund.
    6. Cristina Arellano & Ananth Ramanarayanan, 2008. "Default and the maturity structure in sovereign bonds," Globalization and Monetary Policy Institute Working Paper 19, Federal Reserve Bank of Dallas.
    7. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    8. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
    9. repec:acb:camaaa:2009-15 is not listed on IDEAS
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