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Default risk, sectoral reallocation, and persistent recessions

Cristina Arellano, Yan Bai and Gabriel Mihalache ()

Journal of International Economics, 2018, vol. 112, issue C, 182-199

Abstract: Sovereign debt crises are associated with large and persistent declines in economic activity, disproportionately so for nontradable sectors. This paper documents this pattern using Spanish data and builds a two-sector, dynamic quantitative model of sovereign default with capital accumulation. Recessions are very persistent in the model and more pronounced for nontraded sectors because of default risk. An adverse domestic shock increases the likelihood of default, limits capital inflows, and thus restricts the ability of the economy to exploit investment opportunities. The economy responds by reducing investment and reallocating capital toward the traded sector to support debt service payments. The real exchange rate depreciates, a reflection of the scarcity of traded goods. We find that these mechanisms are quantitatively important for rationalizing the experience of Spain during the recent debt crisis.

Keywords: European debt crisis; Traded and nontraded production; Real exchange rate; Capital accumulation; Sovereign default with production economy (search for similar items in EconPapers)
JEL-codes: F3 E3 (search for similar items in EconPapers)
Date: 2018
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Chapter: Default Risk, Sectoral Reallocation, and Persistent Recessions (2017)
Working Paper: Default Risk, Sectoral Reallocation and Persistent Recessions (2017) Downloads
Working Paper: Default Risk, Sectoral Reallocation, and Persistent Recessions (2017) Downloads
Working Paper: Default Risk, Sectoral Reallocation, and Persistent Recessions (2017) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:eee:inecon:v:112:y:2018:i:c:p:182-199

DOI: 10.1016/j.jinteco.2018.01.004

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