A solution to the default risk-business cycle disconnect

Enrique G. Mandoza and Vivian Yue

No 924, International Finance Discussion Papers from Board of Governors of the Federal Reserve System (U.S.)

Abstract: Models of business cycles in emerging economies explain the negative correlation between country spreads and output by modeling default risk as an exogenous interest rate on working capital. Models of strategic default explain the cyclical properties of sovereign spreads by assuming an exogenous output cost of default with special features, and they underestimate debt-output ratios by a wide margin. This paper proposes a solution to this default risk-business cycle disconnect based on a model of sovereign default with endogenous output dynamics. The model replicates observed V-shaped output dynamics around default episodes, countercyclical sovereign spreads, and high debt ratios, and it also matches the variability of consumption and the countercyclical fluctuations of net exports. Three features of the model are key for these results: (1) working capital loans pay for imported inputs; (2) imported inputs support more efficient factor allocations than when these inputs are produced internally; and (3) default on the foreign obligations of firms and the government occurs simultaneously.

Keywords: Business cycles; Emerging markets (search for similar items in EconPapers)
Date: 2008
New Economics Papers: this item is included in nep-bec, nep-dge, nep-mac and nep-rmg
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Citations: View citations in EconPapers (40)

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Related works:
Working Paper: A Solution to the Default Risk-Business Cycle Disconnect (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgif:924

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