Interactions-among-default-risk-output-and-an-equilibrium-interest-rate
The model describes interactions among default risk, output, and an equilibrium interest rate that includes a premium for endogenous default risk. The decision maker is a government of a small open economy that borrows from risk-neutral foreign creditors. The foreign lenders must be compensated for default risk. The government borrows and lends abroad in order to smooth the consumption of its citizens. The government repays its debt only if it wants to, but declining to pay has adverse consequences. The interest rate on government debt adjusts in response to the state-dependent default probability chosen by government. The model yields outcomes that help interpret sovereign default experiences, including countercyclical interest rates on sovereign debt countercyclical trade balances high volatility of consumption relative to output Notably, long recessions caused by bad draws in the income process increase the government’s incentive to default. This can lead to spikes in interest rates temporary losses of access to international credit markets large drops in output, consumption, and welfare large capital outflows during recessions Such dynamics are consistent with experiences of many countries.
