Working Paper: CEPR ID: DP10697
Authors: Seunghoon Na; Stephanie Schmitt-Groh; MartÃn Uribe; Vivian Yue
Abstract: This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. By contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have stronger default incentives and therefore support less external debt than economies with optimally floating rates.
Keywords: capital controls; currency pegs; downward nominal wage rigidity; exchange rates; optimal monetary policy; sovereign default
JEL Codes: E43; E52; F31; F34; F38; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| sovereign default (F34) | currency devaluation (F31) |
| negative endowment shocks (G59) | consumption contractions (E21) |
| consumption contractions (E21) | unemployment pressures (J64) |
| unemployment pressures (J64) | downward nominal wage rigidity (J31) |
| downward nominal wage rigidity (J31) | involuntary unemployment (J64) |
| currency devaluation (F31) | real wages (J31) |
| currency devaluation (F31) | employment (J68) |
| fixed exchange rates (F31) | higher default incentives (G32) |
| fixed exchange rates (F31) | less external debt (F34) |
| higher default incentives (G32) | involuntary unemployment (J64) |
| sovereign default (F34) | involuntary unemployment (J64) |