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Source: International Monetary Fund

Constrained Efficient Borrowing with Sovereign Default Risk

Author/Editor:

Juan Carlos Hatchondo ; Leonardo Martinez ; Francisco Roch

Publication Date:

November 8, 2020

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary:

Using a quantitative sovereign default model, we characterize constrained efficient borrowing by a Ramsey government that commits to income-history-contingent borrowing paths taking as given ex-post optimal future default decisions. The Ramsey government improves upon the Markov government because it internalizes the effects of borrowing decisions in period t on borrowing opportunities prior to t. We show the effect of borrowing decisions in t on utility flows prior to t can be encapsulated by two single dimensional variables. Relative to a Markov government, the Ramsey government distorts borrowing decisions more when bond prices are more sensitive to borrowing, and changes in bond prices have a larger effect on past utility. In a quantitative exercise, more than 80% of the default risk is eliminated by a Ramsey government, without decreasing borrowing. The Ramsey government also has a higher probability of completing a successful deleveraging (without defaulting), while smoothing out the fiscal consolidation.

Series:

Working Paper No. 20/227

Frequency:

regular

English

Publication Date:

November 8, 2020

ISBN/ISSN:

9781513560366/1018-5941

Stock No:

WPIEA2020227

Format:

Paper

Pages:

61

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