Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation
35 Pages Posted: 5 Sep 2009 Last revised: 23 Dec 2011
Date Written: February 6, 2010
Abstract
Sovereign default often affects country’s trade relations. The defaulter’s currency depreciates while trade volume falls drastically. To explain this connection, this study proposes a model to incorporate real depreciation along with sovereign bankruptcy. Defaulters must exchange more of their own goods for imports, which stimulates an adjustment to the equilibrium exchange rate. We demonstrate that a default episode can imply up to a 30% real depreciation. This matches the depreciations observed in crisis events for developing countries. To avoid this, countries are willing to maintain borrowing obligations up to a realistic level of debt.
Keywords: endogenous default, endogenous exchange rate, trade balance
JEL Classification: F34, F11, F17
Suggested Citation: Suggested Citation
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