Sovereign debt spread and default in a model with self-fulfilling prophecies ans asymmetric information

Christophe Blot (), Bruno Ducoudré and Xavier Timbeau

No 2015-12, Documents de Travail de l'OFCE from Observatoire Francais des Conjonctures Economiques (OFCE)

Abstract: The outbreak of the Greek crisis has revived the literature on the sovereign debt spreads. Recent evidence has shed new lights on the main determinants of interest rates spreads. The sharp increase of government bond yields cannot be entirely attributed tochanges in macroeconomic fundamentals. Contagion effects can occur and self-fulfilling speculation may arise. Yet, this literature has been mainly empirical and needs sound theoretical foundations. The aim of this paper is to fill in this gap. We develop a simple model in the spirit of second generation currency crises models developed by (Obstfled, 1996). The model describes a strategic game between governments and financial markets. Eurozone countries face a trade-off as governments may either commit and implement restrictive fiscal policies or default on debt. The cost of the commitment strategy increases when interest rates increase or when the fiscal multipliers are high. This leaves the opportunity for speculators to drive the economy towards a bad equilibrium,forcing the government to renege its commitment. We introduce a source of uncertainty about the cost of default in the model. By this way, we may introduce the possibility that governments do not default although risk premiums on bond yield is high.

Keywords: Sovereign default; risk premium; multiple equilibria; asymmetric information (search for similar items in EconPapers)
JEL-codes: E44 E61 H63 (search for similar items in EconPapers)
Date: 2015-04
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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