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Optimal External Debt and Default

Bernardo Guimarães

London School of Economics & Political Science (LSE) - Department of Economics

January 2007

CEPR Discussion Paper No. 6035

This paper analyses whether sovereign default episodes can be seen as contingencies of optimal international lending contracts. The model considers a small open economy with capital accumulation and without commitment to repay debt. Taking first order approximations of Bellman equations, I derive analytical expressions for the equilibrium level of debt and the optimal debt contract. In this environment, debt relief generated by reasonable fluctuations in productivity is an order of magnitude below that generated by shocks to world interest rates. Debt relief prescribed by the model following the interest rate hikes of 1980-81 accounts for a substantial part of the debt forgiveness obtained by the main Latin American countries through the Brady agreements.

Number of Pages in PDF File: 39

Keywords: Default, optimal contract, sovereign debt, world interest rates

JEL Classification: F3, F4, G1

Date posted: June 27, 2007  

Suggested Citation

Guimarães, Bernardo, Optimal External Debt and Default (January 2007). CEPR Discussion Paper No. 6035. Available at SSRN: https://ssrn.com/abstract=996884

Contact Information

Bernardo Guimarães (Contact Author)
London School of Economics & Political Science (LSE) - Department of Economics ( email )
Houghton Street
London WC2A 2AE
United Kingdom
+44 (0)20 7955 7502 (Phone)
HOME PAGE: http://personal.lse.ac.uk/guimarae
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