Commitment in the Canonical Sovereign Default Model

Xavier Mateos-Planas, Sean McCrary, Jose-Victor Rios-Rull and Adrien Wicht
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Xavier Mateos-Planas: Queen Mary University of London and CfM
Sean McCrary: University of Pennsylvania
Jose-Victor Rios-Rull: University of Pennsylvania, CAERP, UCL, CEPR and NBER

PIER Working Paper Archive from Penn Institute for Economic Research, Department of Economics, University of Pennsylvania

Abstract: We study the role of lack commitment in shaping the allocations of the canonical incompletemarkets sovereign default model of Eaton and Gersovitz (1981). We show how the equilibrium with commitment to the circumstances under which default can be undertaken involves a very different set of functional equations than in the equilibrium without commitment. It turns out that, in practice, under commitment default does not exist in all but very extreme quantitative environments. We document how the standard specification of Arellano (2008) displays no default if there is commitment, even in the absence of both utility cost and exclusion from borrowing. While less standard specifications can produce some default under commitment, we provide examples that demonstrate how rare default is. We interpret default as a recourse of last resort.Length: 13 pages

Date: 2023-03-01
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