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Private Leverage and Sovereign Default

Author

Listed:
  • Yan Bai

    (University of Rochester)

  • Luigi Bocola

    (Northwestern University)

  • Cristina Arellano

    (Federal Reserve Bank of Minneapolis)

Abstract

During the recent European debt crisis, sovereign spreads rose substantially and economic activity collapsed. In this paper, we develop an integrated framework of government debt crises and aggregate fluctuations in an environment of firms default risk. Firms face interest rates that depend on their default risk and also on government default risk. We consider two sources of aggregate fluctuations; one arising from the public sector that directly affects government spreads and another one arising in the private sector which affects the productivity of all firms. Public shocks affect firms differentially based on their credit needs. Aggregate productivity shocks, in contrast, affect all firms equally. We use firm level data and our model to identify the source of the crisis. We find that public shocks account for about 50% of the decline in output for Italy.

Suggested Citation

  • Yan Bai & Luigi Bocola & Cristina Arellano, 2016. "Private Leverage and Sovereign Default," 2016 Meeting Papers 309, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:309
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