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History Remembered: Optimal Sovereign Default on Domestic and External Debt

Pablo D'Erasmo () and Enrique Mendoza ()

No 19-31, Working Papers from Federal Reserve Bank of Philadelphia

Abstract: Infrequent but turbulent overt sovereign defaults on domestic creditors are a “for- gotten history” in macroeconomics. We propose a heterogeneous-agents model in which the government chooses optimal debt and default on domestic and foreign creditors by balancing distributional incentives versus the social value of debt for self-insurance, liquidity, and risk-sharing. A rich feedback mechanism links debt issuance, the distribution of debt holdings, the default decision, and risk premia. Calibrated to Eurozone data, the model is consistent with key long-run and debt-crisis statistics. Defaults are rare (1.2 percent frequency) and preceded by surging debt and spreads. Debt sells at the risk-free price most of the time, but the government’s lack of commitment reduces sustainable debt sharply.

Keywords: public debt; sovereign default; debt crisis; European crisis (search for similar items in EconPapers)
JEL-codes: E44 E6 F34 H63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-mac and nep-opm
Date: 2019-07-22
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Working Paper: History Remembered: Optimal Sovereign Default on Domestic and External Debt (2018) Downloads
Working Paper: History Remembered: Optimal Sovereign Default on Domestic and External Debt (2018) Downloads
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DOI: https://doi.org/10.21799/frbp.wp.2019.31

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