Optimal Borrowing Through the Business Cycle
30 Pages Posted: 5 Sep 2014
Date Written: September 3, 2014
Abstract
This paper studies optimal levels of borrowing at each point of a given business cycle when default is considered a possible optimal decision. It also searches for parameters that can cause the sustainable equilibrium of different points in the business cycle to become unstable, or nonexistent. This is achieved by performing simulations for different values of the parameters. Relevant parameters include time of exclusion from the financial markets after a default, interest rates, volatility of production, average production increases after inclusion, and the discount factor.
An economy can borrow the most when growth is expected in the near future, while borrowing should be minimized when the cycle is ebbing. All else constant, short punishment periods, excessively high interest rates, and low patience levels increase the incentives to default. The paper shows that there is a minimum gain from participation in the financial sector that is necessary to eliminate the incentives to default, and greater benefits allow for greater borrowing.
Even the wealthier countries require a minimum positive shift in average production to accept the greater volatility that is assumed to come with inclusion in the global financial market. There is also a minimum autarkic production that is necessary. Very poor countries need higher gains from inclusion to participate in the market. A study on the effects of volatility in production is also presented.
Keywords: Dynamic Programming, Sovereign Debt, Business Cycle, Volatility
JEL Classification: C61, F34, F41, G15, H63
Suggested Citation: Suggested Citation