A Model of the Twin Ds: Optimal Default and Devaluation

34 Pages Posted: 13 Jul 2015

See all articles by Seunghoon Na

Seunghoon Na

Purdue University - Department of Economics

Stephanie Schmitt-Grohé

Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Martín Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)

Vivian Z. Yue

Emory University; Federal Reserve Bank of Atlanta

Multiple version iconThere are 3 versions of this paper

Date Written: July 2015

Abstract

This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. By contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have stronger default incentives and therefore support less external debt than economies with optimally floating rates.

Keywords: capital controls, currency pegs, downward nominal wage rigidity, exchange rates, optimal monetary policy, sovereign default

JEL Classification: E43, E52, F31, F34, F38, F41

Suggested Citation

Na, Seunghoon and Schmitt-Grohe, Stephanie and Uribe, Martin and Yue, Vivian, A Model of the Twin Ds: Optimal Default and Devaluation (July 2015). CEPR Discussion Paper No. DP10697, Available at SSRN: https://ssrn.com/abstract=2630125

Seunghoon Na (Contact Author)

Purdue University - Department of Economics ( email )

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Stephanie Schmitt-Grohe

Centre for Economic Policy Research (CEPR) ( email )

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National Bureau of Economic Research (NBER)

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Martin Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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Vivian Yue

Emory University ( email )

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HOME PAGE: http://vivianyue.com

Federal Reserve Bank of Atlanta ( email )

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