Calibrating the Cost of Defaulting in Models of Sovereign Defaults

Abstract

This paper develops a DSGE model of sovereign default and contagion for small open economies that have common risk averse international investors. The financial links generated by these investors explain the endogenous determination of credit limits, capital flows, and the risk premium in sovereign bond prices. In equilibrium, these variables are a function of both an economy's own fundamentals and the fundamentals of other economies. The model is able to replicate both the Wealth and Portfolio Recomposition channels of contagion. Quantitatively, the model is consistent with the contagion of the Argentinean crisis to Uruguay and the Russian crisis to Brazil. JEL Classification: F32; F34; F36; F42

Constrained Efficient Borrowing with Sovereign Default Risk

“…This is a key parameter determining the government's willingness to tolerate consumption fluctuations and thus the optimal cyclicality of fiscal policy. Overall, we use the simulations to calibrate the value of four parameters: the values for the default cost d 0 and d 1 mainly determine the average debt and spread levels (Hatchondo and Martinez, 2017), σ U mainly determines the spread volatility, and γ is determined mainly by the consumption-volatility target.…”

Constrained Efficient Borrowing with Sovereign Default Risk

“…We choose these four parameters to match four targets in the data: (i) a public debt-to-income ratio of 43.5 percent (IMF Fiscal Affairs Department Historical Public Debt database), (ii) a mean level of spreads of 240 basis points, (iii) a spread volatility of 100 basis points, and (iv) a volatility of consumption relative to output equal to one. The values for the default cost d 0 and d 1 mainly determine the average debt and spread levels (Hatchondo and Martinez, 2017), σ U mainly determines the spread volatility, and γ is determined mainly by the consumption-volatility target.…”