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The Generalized Euler Equation and the Unilateral Default Problem

Author

Listed:
  • Jose-Victor Rios-Rull

    (University of Pennsylvania)

  • Xavier Mateos-Planas

    (Queen Mary University of London)

Abstract

We show how to characterize Markov equilibria in a class of models of unilateral debt default by means of analytical functional equations. By treating equilibrium conditions as constraints in the decision problem of the agent,the equilibrium turns into a game between the borrower and its future selves. Given the time-inconsistent nature of the decision problem, the Generalized Euler Equation includes derivatives of decision rules as its arguments. The functional equations give insights into and explicitly identify the various economic relevant margins. The computational method relies on Hermitian splines to provide controlled accuracy. A comparison with the functional equations for the problem under commitment provides additional insights into the environments without commitment. We apply this approach to several problems from the recent literature on sovereign debt with incomplete markets.

Suggested Citation

  • Jose-Victor Rios-Rull & Xavier Mateos-Planas, 2016. "The Generalized Euler Equation and the Unilateral Default Problem," 2016 Meeting Papers 641, Society for Economic Dynamics.
    • Handle: RePEc:red:sed016:641
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    References listed on IDEAS

    as
    1. Diego J. Perez, 2015. "Sovereign Debt, Domestic Banks and the Provision of Public Liquidity," Discussion Papers 15-016, Stanford Institute for Economic Policy Research.
    2. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & José-Víctor Ríos-Rull, 2007. "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default," Econometrica, Econometric Society, vol. 75(6), pages 1525-1589, November.
    3. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 48(2), pages 289-309.
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