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Optimal sovereign default

  • Adam, Klaus
  • Grill, Michael

When is it optimal for a government to default on its legal repayment obligations? We answer this question for a small open economy with domestic production risk in which contracting frictions make it optimal for the government to finance itself by issuing non-contingent debt. We show that Ramsey optimal policies occasionally deviate from the legal repayment obligation and repay debt only partially, even if such deviations give rise to significant 'default costs'. Optimal default improves the international diversification of domestic output risk, increases the efficiency of domestic investment and - for a wide range of default costs - significantly increases welfare relative to a situation where default is simply ruled out from Ramsey optimal plans. We show analytically that default is optimal following adverse shocks to domestic output, especially for very negative international wealth positions. A quantitative analysis reveals that for empirically plausible wealth levels, default is optimal only in response to disaster-like shocks to domestic output, and that following such shocks default can be Ramsey optimal even if the net foreign asset position is positive.

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Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Papers with number 09/2013.

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Date of creation: 2013
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Handle: RePEc:zbw:bubdps:092013
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  10. Cruces, Juan J. & Trebesch, Christoph, 2013. "Sovereign defaults: The price of haircuts," Munich Reprints in Economics 20036, University of Munich, Department of Economics.
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  14. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
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  17. William R. Zame, 1990. "Efficiency and the Role of Default When Security Markets are Incomplete," UCLA Economics Working Papers 585, UCLA Department of Economics.
  18. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2001. "Default and Punishment in General Equilibrium," Cowles Foundation Discussion Papers 1304, Cowles Foundation for Research in Economics, Yale University.
  19. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
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  21. Michael Grill & Johannes Brumm, 2010. "Computing Equilibria in Dynamic Models with Occasionally Binding Constraints," 2010 Meeting Papers 695, Society for Economic Dynamics.
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