Trade-off Between International and Domestic Risk Sharing in the Presence of Sovereign Risk

39 Pages Posted: 7 Jul 2010

See all articles by Veronica Rappoport

Veronica Rappoport

London School of Economics & Political Science (LSE)

Date Written: July 6, 2010

Abstract

This paper analyzes how sovereign risk affects government's ability to smooth domestic risk when policy tools imperfectly discriminate foreign and domestic agents. The government cannot choose to pay differently foreign and domestic bond holders; however it can imperfectly discriminate against foreign investors by reducing overall debt payments and lowering domestic tax burden accordingly. This paper shows that, in an overlapping generations economy with privately observable idiosyncratic risk, this distortion results in excessive consumption inequality in the cross-section of domestic agents and excessive consumption volatility in the time series. Opening the capital account enables international risk sharing, but also introduces this government's distortion. Its overall effect on consumption risk is therefore ambiguous.

Keywords: sovereign risk, risk sharing, markov perfect equilibrium

JEL Classification: F34, F36, G15

Suggested Citation

Rappoport, Veronica, Trade-off Between International and Domestic Risk Sharing in the Presence of Sovereign Risk (July 6, 2010). Available at SSRN: https://ssrn.com/abstract=1635427 or http://dx.doi.org/10.2139/ssrn.1635427

Veronica Rappoport (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

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