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Sovereign Default and Liquidity: the Case for a World Safe Asset

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  • François Le Grand

    (EMLYON Business School)

  • Xavier Ragot

    (Observatoire français des conjonctures économiques)

Abstract

We present a general equilibrium model of the world economy where sovereigns face idiosyncratic risks and can default on their debt. In this model, the world interest rate is determined through the global financial market equilibrium, the amount of safe asset is endogenous and determines international risk sharing. Non-trivial multiple equilibria naturally arise, due to the endogeneity of the interest rate. These equilibria can be ranked according to their aggregate welfare, such that equilibria with a higher quantity of safe assets correspond to higher welfare. Due to a shortage in the safe asset supply, even the equilibrium with the highest welfare is not constrained-efficient. Finally, we prove that a world fund issuing a safe asset can reach the constrained-efficient aggregate welfare. With a standard calibration, the size of the fund is found to be around 4.1% of the world GDP. Its relationship with the Special Drawing Rights of the IMF is discussed.

Suggested Citation

  • François Le Grand & Xavier Ragot, 2017. "Sovereign Default and Liquidity: the Case for a World Safe Asset," Sciences Po publications 2017-05, Sciences Po.
  • Handle: RePEc:spo:wpmain:info:hdl:2441/3jhmd4ib388m99gnolvi8klga2
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    More about this item

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • O19 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - International Linkages to Development; Role of International Organizations

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