Domestic and External Debt and Default

Dirk Niepelt

No 635, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: We develop a general equilibrium model with defaultable domestic and external debt. Overlapping generations work, consume, accumulate capital and public debt. Successive, democratically elected governments choose taxes, public goods spending, domestic and external debt issuance and repayment. In Markov perfect equilibrium, political distortions inherent in democratic societies strengthen debt capacity; macroeconomic shocks affect the cost of public funds and debt returns; and debt serves intergenerational risk sharing. Default decisions may or may not be correlated across debt tranches. Minimum debt returns raise the cost of public funds ex post and render default on other tranches more likely; ex ante, they increase the revenue from debt sales but crowd out capital. Political and general equilibrium "wedges" undermine the inter-temporal smoothing of the shadow cost of public funds. Under standard functional form assumptions the model is solved in closed form.

Date: 2016
New Economics Papers: this item is included in nep-dge
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