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Federal Reserve Bank of Atlanta
FRB Atlanta CQER Working Paper
A model of the Twin Ds: optimal default and devaluation
Seunghoon Na
Stephanie Schmitt-Grohe
Martin Uribe
Vivian Z. Yue
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.


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Seunghoon Na & Stephanie Schmitt-Grohe & Martin Uribe & Vivian Z. Yue, A model of the Twin Ds: optimal default and devaluation, Federal Reserve Bank of Atlanta, FRB Atlanta CQER Working Paper 2015-1, 01 Apr 2015.
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Keywords: sovereign default; exchange rates; optimal monetary policy; capital controls; downward nominal wage rigidity; currency pegs
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