International Borrowing, Investment and Default

Guido Lorenzoni (), Fabrizio Perri and Veronica Guerrieri
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Veronica Guerrieri: U of Chicago

No 952, 2008 Meeting Papers from Society for Economic Dynamics

Abstract: In this paper, we present a tractable model of a small open economy where the main driver of international borrowing is investment. Debt is non-state-contingent and the choice of default is endogenous, as in Eaton and Gersovitz (1981). By introducing a simple AK technology, we obtain a setup where countries can be permanent debtors (or permanent creditors). In particular, a country will be a net borrower when the expected productivity of capital, adjusted for risk, is higher than the world interest rate. Moreover, we can derive analytically the equilibrium level of debt and the probability of default, and look at the effects of expected productivity on both. The model can deliver higher default frequencies and higher borrowing levels than consumption smoothing models.

Date: 2008
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