A Solution to the Disconnect between Country Risk and Business Cycle Theories

Enrique Mendoza and Vivian Yue

No 13861, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We propose a model that solves the crucial disconnect between business cycle models that treat default risk as an exogenous interest rate on working capital, and sovereign default models that treat output fluctuations as an exogenous process with ad-hoc default costs. The model explains observed output dynamics around defaults, countercyclical spreads, high debt ratios, and key business cycle moments. Three features of the model are central for these results: working capital loans pay for imported inputs; default triggers an efficiency loss as imported inputs are replaced by imperfect domestic substitutes; and default on public and private foreign obligations occurs simultaneously.

JEL-codes: E32 E44 F32 F34 (search for similar items in EconPapers)
Date: 2008-03
New Economics Papers: this item is included in nep-bec, nep-dge, nep-mac and nep-rmg
Note: IFM
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Citations: View citations in EconPapers (20)

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