A General Equilibrium Model of Sovereign Default and Business Cycles

Abstract

for helpful comments and suggestions. We also acknowledge comments by participants at various seminars and conferences. † This version of the paper was prepared while Enrique Mendoza was a visiting scholar with the Research Department, and he is grateful for Department's hospitality and support. Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-noc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around deraults, countercyclical spreads, high debt ratios, and key business cycle moments. This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Sovereign defaults and banking crises

“…In particular, a related work is by Mendoza and Yue (2012) who are the first to endogenize the cost of default: a sovereign default forces the private sector to use less efficient resources. We propose an alternative and complementary source for output costs: a disruption in domestic lending triggered by nonperforming sovereign bonds in domestic banks' balance sheets.…”

“…Argentina's output dynamics before and after the default event mostly lie within the 99% confidence bands of the model simulations. As in Mendoza and Yue (2012), the v-shaped recovery of output after a default event is driven by two forces: TFP and re-access to credit. TFP is mean-reverting and thus very likely to recover after defaults.…”

Fewer but Better: Sudden Stops, Firm Entry, and Financial Selection

“…Guerrón-Quintana and Jinnai (2014) use a similar framework to study the effect of the 2008-09 liquidity crash on U.S. economic growth. Gornemann (2014) combines the endogenous default model of Mendoza and Yue (2012) with the variety model of Romer (1990) to study how endogenous growth affects the decision of the sovereign to default. Because default increases the price of imported intermediate goods in his model, it decreases the expected profits of potential entrants and, hence, depresses productivity growth.…”

News and sovereign default risk in small open economies

“…Figure 13 During that period, the average debt-to-GDP ratio for developed economies is about 10 percentage points higher than that in emerging economies. 30 How do the differences in precision levels affect debt and default dynamics in our model? The left panels of Figure plot the debt level as a function of the news precision and corresponding Theill's Us in the upper and lower panels, respectively.…”

“…29 Notice that on the right panel of Figure 6 the country with Theill's U coefficient 0.8 (Peru) appears as an outlier. 30 Reinhart, Rogoff and Savastano (2003) The upper left panel shows the default rates by income decile that we estimate using data for 118 countries covering 1950-2003. The upper right and lower panels plot the number of defaults and the associated opacity or Theill's U measures.…”