Working Paper: NBER ID: w13861
Authors: Enrique G. Mendoza; Vivian Z. Yue
Abstract: 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.
Keywords: Country Risk; Business Cycle; Sovereign Default; Output Dynamics
JEL Codes: E32; E44; F32; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| sovereign default (F34) | output fluctuations (E39) |
| efficiency loss (D61) | output fluctuations (E39) |