A General Equilibrium Model of Sovereign Default and Business Cycles
Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-hoc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around defaults, countercyclical spreads, high debt ratios, and key business cycle moments.
Earlier versions of this paper circulated under the title "A Solution to the Disconnect between Country Risk and Business Cycles Theories." We thank Cristina Arellano, Mark Aguiar, Andy Atkeson, Fernando Broner, Jonathan Eaton, Gita Gopinath, Jonathan Heathcote, Olivier Jeanne, Pat Kehoe, Tim Kehoe, Narayana Kocherlakota, Guido Lorenzoni, Andy Neumeyer, Fabrizio Perri, Victor Rios-Rull, Tom Sargent, Stephanie Schmitt-Grohe, Martin Uribe, Mark Wright, and Jing Zhang for helpful comments and suggestions. We also acknowledge valuable comments by participants at various seminars and conferences since 2007. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Enrique G. Mendoza & Vivian Z. Yue, 2012. "A General Equilibrium Model of Sovereign Default and Business Cycles," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 889-946. citation courtesy of