Default Risk, Sectoral Reallocation, and Persistent Recessions

37 Pages Posted: 18 Sep 2017 Last revised: 18 Aug 2021

See all articles by Cristina Arellano

Cristina Arellano

Federal Reserve Bank of Minneapolis

Yan Bai

University of Rochester - Department of Economics

Gabriel Mihalache

Stony Brook University

Date Written: September 2017

Abstract

Sovereign debt crises are associated with large and persistent declines in economic activity, disproportionately so for nontradable sectors. This paper documents this pattern using Spanish data and builds a two-sector dynamic quantitative model of sovereign default with capital accumulation. Recessions are very persistent in the model and more pronounced for nontraded sectors because of default risk. An adverse domestic shock increases the likelihood of default, limits capital inflows, and thus restricts the ability of the economy to exploit investment opportunities. The economy responds by reducing investment and reallocating capital toward the traded sector to support debt service payments. The real exchange rate depreciates, a reflection of the scarcity of traded goods. We find that these mechanisms are quantitatively important for rationalizing the experience of Spain during the recent debt crisis.

Suggested Citation

Arellano, Cristina and Bai, Yan and Mihalache, Gabriel, Default Risk, Sectoral Reallocation, and Persistent Recessions (September 2017). NBER Working Paper No. w23835, Available at SSRN: https://ssrn.com/abstract=3038663

Cristina Arellano (Contact Author)

Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

Yan Bai

University of Rochester - Department of Economics ( email )

Harkness Hall
Rochester, NY 14627
United States

Gabriel Mihalache

Stony Brook University ( email )

SBS S633
Stony Brook, NY NY 11794
United States

HOME PAGE: http://www.gmihalache.com/

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