Working Paper: NBER ID: w17151
Authors: Enrique G. Mendoza; Vivian Z. Yue
Abstract: 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.
Keywords: Sovereign Default; Business Cycles; General Equilibrium
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 |
|---|---|
| Default (Y70) | Economic Downturn (F44) |
| Interest Rates on Sovereign Debt (E43) | Output (Y10) |
| Default (Y70) | Efficiency Loss (D61) |
| Efficiency Loss (D61) | Production Efficiency (D24) |
| Fall in Productivity (O49) | Likelihood of Default (G33) |
| Fall in Productivity (O49) | Sovereign Spreads (H63) |
| Sovereign Spreads (H63) | Firms' Financing Costs (G32) |
| Firms' Financing Costs (G32) | Output (Y10) |
| External Debt as a Share of GDP (F34) | Likelihood of Default (G33) |