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Federal Reserve Bank of St. Louis
Working Papers
Equilibrium Sovereign Default with Exchange Rate Depreciation
Sergey V. Popov
David Wiczer

This study proposes and quantitatively assesses a terms-of-trade penalty for defaulting: defaulters must exchange more of their own goods for imports, which causes an adjustment to the equilibrium exchange rate. This penalty can take the place of an ad hoc fall in output: Facing only this penalty and temporary exclusion from debt markets, countries are willing to maintain borrowing obligations up to a realistic level of debt. The terms-of-trade penalty is consistent with the observed relationship between sovereign default and a country's trade flows and prices. The defaulter's currency depreciates while trade volume falls drastically. We demonstrate that a default episode can imply up to a 30% real depreciation, which matches observed crisis events in developing countries.

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Sergey V. Popov & David Wiczer, Equilibrium Sovereign Default with Exchange Rate Depreciation, Federal Reserve Bank of St. Louis, Working Papers 2014-49, 24 Nov 2014.
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Keywords: endogenous default; exchange rate; trade balance.
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