The Aggregate-Demand Doom Loop: Precautionary Motives and the Welfare Costs of Sovereign Risk

52 Pages Posted: 28 Jan 2021

See all articles by Francisco Roldán

Francisco Roldán

International Monetary Fund (IMF) - Research Department

Multiple version iconThere are 2 versions of this paper

Date Written: December 2020

Abstract

Sovereign debt crises coincide with deep recessions. I propose a model of sovereign debt that rationalizes large contractions in economic activity via an aggregate-demand amplification mechanism. The mechanism also sheds new light on the response of consumption to sovereign risk, which I document in the context of the Eurozone crisis. By explicitly separating the decisions of households and the government, I examine the interaction between sovereign risk and precautionary savings. When a default is likely, households anticipate its negative consequences and cut consumption for self-insurance reasons. Such shortages in aggregate spending worsen economic conditions through nominal wage rigidities and boost default incentives, restarting the vicious cycle. I calibrate the model to Spain in the 2000s and find that about half of the output contraction is caused by default risk. More generally, sovereign risk exacerbates volatility in consumption over time and across agents, creating large and unequal welfare costs even if default does not materialize.

JEL Classification: E20, F30, G20, E21, E25, H63, J30

Suggested Citation

Roldán, Francisco, The Aggregate-Demand Doom Loop: Precautionary Motives and the Welfare Costs of Sovereign Risk (December 2020). IMF Working Paper No. 2020/293, Available at SSRN: https://ssrn.com/abstract=3774928

Francisco Roldán (Contact Author)

International Monetary Fund (IMF) - Research Department ( email )

700 19th Street NW
Washington, DC 20431
United States

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