Optimal Domestic (and External) Sovereign Default

76 Pages Posted: 20 Jun 2017

See all articles by Pablo D'Erasmo

Pablo D'Erasmo

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Enrique G. Mendoza

National Bureau of Economic Research (NBER); University of Pennsylvania

Multiple version iconThere are 3 versions of this paper

Date Written: 2017-02-10

Abstract

Infrequent but turbulent episodes of outright sovereign default on domestic creditors are considered a “forgotten history” in macroeconomics. We propose a heterogeneous-agents model in which optimal debt and default on domestic and foreign creditors are driven by distributional incentives and endogenous default costs due to value of debt for self-insurance, liquidity, and risk-sharing. The government’s aim to redistribute resources across agents and through time in response to uninsurable shocks produces a rich dynamic feedback mechanism linking debt issuance, the distribution of government bond holdings, the default decision, and risk premia. Calibrated to Spanish data, the model is consistent with key cyclical comovements and features of debt-crisis dynamics. Debt exhibits protracted fluctuations. Defaults have a low frequency of 0.93 percent, are preceded by surging debt and spreads, and occur with relatively low external debt. Default risk limits the sustainable debt, and yet spreads are zero most of the time.

Keywords: public debt, sovereign default, debt crisis, European crisis

JEL Classification: E44, E6, F34, H63

Suggested Citation

D'Erasmo, Pablo and Mendoza, Enrique G., Optimal Domestic (and External) Sovereign Default (2017-02-10). FRB of Philadelphia Working Paper No. 17-4. Available at SSRN: https://ssrn.com/abstract=2989555

Pablo D'Erasmo (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Enrique G. Mendoza

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

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