Universitat Autònoma de Barcelona
We construct a dynamic theory of sovereign debt and structural reforms with three interacting frictions: limited enforcement, limited commitment, and incomplete markets. A sovereign country in recession issues debt to smooth consumption and makes reforms to speed up recovery. The sovereign can renege on debt by suffering a stochastic cost, in which case debt is renegotiated. The competitive Markov equilibrium features large fluctuations in consumption and reform effort. We contrast the equilibrium with an optimal contract with one-sided commitment. A calibrated model can match several salient facts about debt crises. We quantify the welfare effect of relaxing different frictions.
The ADEMU Working Paper Series is being supported by the European Commission Horizon 2020 European Union funding for Research & Innovation, grant agreement No 649396.
Working paper
English
Austerity; Commitment; Debt overhang; Default; European debt crisis; Markov equilibrium; Moral hazard; Renegotiation; Risk premia; Risk sharing; Sovereign debt; Structural reforms
European Commission 649396
Barcelona Graduate School of Economics. ADEMU working paper series ;
open access
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