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Sovereign Default and Liquidity: the Case for a World Safe Asset

François Le Grand and Xavier Ragot ()
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François Le Grand: EMLYON Business School

No 2017-05, Sciences Po Economics Discussion Papers from Sciences Po Departement of Economics

Abstract: We present a general equilibrium model of the world economy where sovereigns face idiosyncratic risks and can default on their debt. In this model, the world interest rate is determined through the global financial market equilibrium, the amount of safe asset is endogenous and determines international risk sharing. Non-trivial multiple equilibria naturally arise, due to the endogeneity of the interest rate. These equilibria can be ranked according to their aggregate welfare, such that equilibria with a higher quantity of safe assets correspond to higher welfare. Due to a shortage in the safe asset supply, even the equilibrium with the highest welfare is not constrained-efficient. Finally, we prove that a world fund issuing a safe asset can reach the constrained-efficient aggregate welfare. With a standard calibration, the size of the fund is found to be around 4.1% of the world GDP. Its relationship with the Special Drawing Rights of the IMF is discussed.

Date: 2017-10
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