NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

A Solution to the Disconnect between Country Risk and Business Cycle Theories

Enrique G. Mendoza, Vivian Z. Yue

NBER Working Paper No. 13861
Issued in March 2008, Revised in December 2011
NBER Program(s):IFM

We propose a model that solves the crucial disconnect between business cycle models that treat default risk as an exogenous interest rate on working capital, and sovereign default models that treat output fluctuations as an exogenous process with ad-hoc default costs. The model explains observed output dynamics around defaults, countercyclical spreads, high debt ratios, and key business cycle moments. Three features of the model are central for these results: working capital loans pay for imported inputs; default triggers an efficiency loss as imported inputs are replaced by imperfect domestic substitutes; and default on public and private foreign obligations occurs simultaneously.

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Document Object Identifier (DOI): 10.3386/w13861

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