Fear of Sovereign Default, Banks, and Expectations-Driven Business Cycles

Christopher Gunn and Alok Johri

No 13-03, Carleton Economic Papers from Carleton University, Department of Economics

Abstract: What is the effect of the fear of future sovereign default on the economy of the defaulting country? The typical sovereign default model does not address this question. In this paper we wish to explore the possibility that changing expectations about future default themselves can lead to financial stress (as measured by credit spreads) and recessionary outcomes. We exploit the \news-shock" framework to consider an environment in which sovereign debt-holders receive imperfect signals about the portion of debt that a sovereign may default on in the future. We then investigate how domestic banks can play a role in transmitting the expectation of default into a realized recession through the interaction of the domestic banks' holdings of government debt and their risk-weighted capital requirements. Our results suggest that, consistent with the data, even in the absence of actual realized government default, an increase in pessimism regarding the prospect of future default results in a rise in yields on government debt and an increase in interest rates on private domestic loans, as well as a recession in the economy.

Keywords: expectations-driven business cycles, sovereign defaults; financial intermediation, news shocks, business cycles, interest rate spreads, capital adequacy requirements. (search for similar items in EconPapers)
JEL-codes: E3 E44 F36 F37 F4 G21 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2013-05
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Published: Carleton Economic Papers

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Working Paper: Fear of Sovereign Default, Banks, and Expectations-driven Business Cycles (2013)
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