A model of the Twin Ds: optimal default and devaluation

Seunghoon Na, Stephanie Schmitt-Grohe, Martín Uribe () and Vivian Yue

No 2015-1, FRB Atlanta CQER Working Paper from Federal Reserve Bank of Atlanta

Abstract: This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages, thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. In contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have stronger default incentives and therefore support less external debt than economies with optimally floating rates.

Keywords: sovereign defaults; exchange rates; optimal monetary policy; capital controls; downward nominal wage rigidity; currency pegs (search for similar items in EconPapers)
JEL-codes: E43 E52 F31 F34 F38 F41 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2015-04-01
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-opm
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Citations: View citations in EconPapers (3)

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Related works:
Working Paper: A Model of the Twin Ds: Optimal Default and Devaluation (2015)
Working Paper: A Model of the Twin Ds: Optimal Default and Devaluation (2015)
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