Working Paper: CEPR ID: DP9178
Authors: Klaus Adam; Michael Grill
Abstract: When is it optimal for a government to default on its legal repayment obligations? We answer this question for a small open economy with domestic production risk in which the government optimally fi?nances itself by issuing non-contingent debt. We show that Ramsey optimal policies occasionally deviate from the legal repayment obligation and repay debt only partially, even if such deviations give rise to signi?cant ?default costs?. Optimal default improves the international diversi?cation of domestic output risk, increases the efficiency of domestic investment and - for a wide range of default costs - signi?cantly increase welfare relative to a situation where default is simply ruled out from Ramsey optimal plans. We show analytically that default is optimal following adverse shocks to domestic output, especially for very negative international wealth positions. A quantitative analysis reveals that for empirically plausible wealth levels, default is optimal only in response to disaster-like shocks to domestic output, and that default can be Ramsey optimal even if the net foreign asset position is positive.
Keywords: Incomplete Markets; Optimal Default; Ramsey Optimal Fiscal Policy
JEL Codes: E62; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Adverse shocks to domestic output (F41) | Optimal default decisions (D91) |
| Optimal default decisions (D91) | Improvement in international diversification of domestic output risk (F29) |
| Optimal default decisions (D91) | Increase in efficiency of domestic investment (E22) |
| Optimal default decisions (D91) | Enhancement of welfare (D60) |
| Default costs (D61) | Optimal default decisions (D91) |
| Wealth position (D31) | Optimal default decisions (D91) |