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Uncertainty shocks and non-fundamental debt crises: An ambiguity approach

Christoph Grosse Steffen

Annual Conference 2015 (Muenster): Economic Development - Theory and Policy from Verein für Socialpolitik / German Economic Association

Abstract: This paper analyses empirically and theoretically the effects of uncertainty shocks on sovereign default risk. It describes a novel mechanism for non-fundamental debt crises induced by uncertainty shocks that are defined as time-varying levels of ambiguity surrounding the macroeconomic fundamental of the economy. A business cycle model with strategic sovereign default is augmented with ambiguity averse investors with multiple-priors utility. I find that uncertainty shocks increase the risk of default as perceived by worst case investors' beliefs. Sovereign and private sector interest rates rise due to a spillover channel that unfolds through the domestic banking sector. A crisis zone is characterised where worst case investors' beliefs lead to non-fundamental debt crises. The model's predictions are shown to be in line with impulse responses obtained from a VAR analysis for a panel of four Euro area countries. Specifically, the dichotomy of sovereign debt pricing in the core and periphery countries can partly be rationalised by accounting for ambiguity premia.

JEL-codes: D81 E44 F34 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-upt
Date: 2015
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