Sovereign risk and firm heterogeneity

Cristina Arellano, Yan Bai and Luigi Bocola

No 547, Staff Report from Federal Reserve Bank of Minneapolis

Abstract: This paper studies the recessionary effects of sovereign default risk using firm-level data and a model of sovereign debt with firm heterogeneity. Our environment features a two-way feedback loop. Low output decreases the tax revenues of the government and raises the risk that it will default on its debt. The associated increase in sovereign interest rate spreads, in turn, raises the interest rates paid by firms, which further depresses their production. Importantly, these effects are not homogeneous across firms, as interest rate hikes have more severe consequences for firms that are in need of borrowing. Our approach consists of using these cross-sectional implications of the model, together with micro data, to measure the effects that sovereign risk has on real economic activity. In an application to Italy, we find that the progressive heightening of sovereign risk during the recent crisis was responsible for 50% of the observed decline in output.

Keywords: Firm heterogeneity; Financial frictions; Sovereign debt crises (search for similar items in EconPapers)
JEL-codes: E44 F34 G12 G15 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2017-03-22
New Economics Papers: this item is included in nep-dge and nep-mac
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmsr:547

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