Default and Interest Rate Shocks: Renegotiation Matters

Victor Almeida (), Carlos Esquivel (), Timothy J. Kehoe () and Juan Pablo Nicolini ()

Department of Economics Working Papers from Universidad Torcuato Di Tella

Abstract: We develop a sovereign default model with debt renegotiation in which interest-rate shocks affect default incentives through two mechanisms. Under the standard mechanism, higher interest rates tighten the government’s budget constraint. Under the renegotiation mechanism, higher rates increase lenders’ opportunity cost of holding delinquent debt, which makes lenders accept larger haircuts and makes default more attractive for the government. We argue that our novel renegotiation mechanism reconciles standard sovereign default models with the narrative that the sharp increase in the real interest rate in the United States was a relevant factor in the defaults of the early 1980s.

Keywords: Sovereign default; Renegotiation; Interest rate shocks (search for similar items in EconPapers)
JEL-codes: F34 F41 G28 (search for similar items in EconPapers)
Pages: 56 pages
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Persistent link: https://EconPapers.repec.org/RePEc:udt:wpecon:2025_10

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