Working Paper

A model of the Twin Ds: optimal default and devaluation


Abstract: This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages, thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. In contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have stronger default incentives and therefore support less external debt than economies with optimally floating rates.

Keywords: optimal monetary policy; capital controls; sovereign default; currency pegs; exchange rates; downward nominal wage rigidity;

JEL Classification: F38; E52; F34; F41; F31; E43;

Access Documents

File(s): File format is application/pdf https://www.frbatlanta.org/-/media/Documents/cqer/publications/workingpapers/2015/1501.pdf?la=en
Description: Full text

Authors

Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: FRB Atlanta CQER Working Paper

Publication Date: 2015-04-01

Number: 2015-1

Pages: 32 pages