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Sovereign debt spread and default in a model with self-fulfilling prophecies and asymmetric information

Christophe Blot (), Bruno Ducoudré and Xavier Timbeau ()

Journal of Macroeconomics, 2016, vol. 47, issue PB, 281-299

Abstract: The euro area sovereign debt crisis has renewed interest in government credibility and the risk of default. Recent empirical evidence has shown that the sharp increase in government bond yields cannot be attributed entirely to changes in macroeconomic fundamentals. Contagion effects can occur, and self-fulfilling speculation may arise. In this paper, we develop a theoretical model in the spirit of the second-generation currency crisis models developed by Obstfled (1996). The model describes a strategic game between governments and private investors. Euro area countries face a trade-off as governments may either commit to and implement restrictive fiscal policies or default on debt. The commitment strategy may not be optimal if the fundamentals deteriorate. The policy maker lose part of their credibility, and governments are forced to default. In addition, we introduce uncertainty about the cost of default in the model, which is then able to account for a greater variety of equilibrium. Thus, when the evaluation of the cost of default is asymmetric, prophecies are not always realized and default does not occur. Simulations of the model then show that it offers insights, and can help to account for the situations of Greece and Italy during the sovereign debt crisis.

Keywords: Sovereign default; Risk premium; Multiple equilibria; Asymmetric information (search for similar items in EconPapers)
JEL-codes: E43 E44 E61 H63 (search for similar items in EconPapers)
Date: 2016
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Working Paper: Sovereign debt spread and default in a model with self-fulfilling prophecies ans asymmetric information (2015) Downloads
Working Paper: Sovereign debt spread and default in a model with self fullfilling prophecies ans asymmetric information (2015) Downloads
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DOI: 10.1016/j.jmacro.2015.10.003

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