Working Paper: NBER ID: w20314
Authors: Seunghoon Na; Stephanie Schmitt-Groh; Martin Uribe; Vivian Z. Yue
Abstract: A salient characteristic of sovereign defaults is that they are typically accompanied by large devaluations. This paper presents new evidence of this empirical regularity known as the Twin Ds and proposes a model that rationalizes it as an optimal policy outcome. The model combines limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default is shown to occur during con- tractions. The role of default is to free up resources for domestic absorption, and the role of exchange-rate devaluation is to lower the real value of wages, thereby reducing involuntary unemployment.
Keywords: sovereign default; devaluation; twin ds phenomenon; nominal rigidities; optimal policy
JEL Codes: 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 defaults (F34) | nominal exchange rate devaluations (F31) |
| default events (Y60) | significant nominal exchange rate changes (F31) |
| downward nominal wage rigidity (J31) | necessitates devaluation (F31) |
| currency peg (F31) | default leads to involuntary unemployment (J65) |
| default (Y70) | involuntary unemployment (J64) |