Domestic Policies and Sovereign Default

RePEc Short ID: pko790
ORCID iD: 0000-0001-8464-2470

Espino, Emilio; Kozlowski, Julian; Martin, Fernando M.; Sanchez, Juan M.

doi:10.20955/wp.2020.017

Working Paper Revision

Domestic Policies and Sovereign Default

Abstract: This paper incorporates fiscal and monetary policies into a model of sovereign default. In addition to the standard present-bias vs default-risk tradeoff faced by governments when choosing debt, distortionary policy instruments introduce an intertemporal tradeoff, which may mitigate or exacerbate the incentives to accumulate debt. Taxation, the money growth rate and currency depreciation all increase with the level of debt. The model reproduces standard business cycle statistics, the response of spreads, inflation and growth to terms-of-trade shocks, and the cyclical properties of fiscal and monetary policies in emerging markets. A counterfactual exercise for Argentina in 2005-2017 suggests that government expansion accounted for the rise in taxes, inflation and currency depreciation and kept output growth low, countering the benign effects of favorable terms of trade.

Keywords: Crises; Default; Sovereign Debt; Exchange Rate; Country Risk; Inflation; Seigniorage; Fiscal Policy; Monetary Policy; Emerging Markets; Latin America;