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Federal Reserve Bank of Philadelphia
Working Papers
Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default
Pablo D'Erasmo
Enrique G. Mendoza

Europe’s debt crisis resembles historical episodes of outright default on domestic public debt about which little research exists. This paper proposes a theory of domestic sovereign default based on distributional incentives affecting the welfare of risk-averse debt and non-debtholders. A utilitarian government cannot sustain debt if default is costless. If default is costly, debt with default risk is sustainable, and debt falls as the concentration of debt ownership rises. A government favoring bondholders can also sustain debt, with debt rising as ownership becomes more concentrated. These results are robust to adding foreign investors, redistributive taxes, or a second asset.

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Pablo D'Erasmo & Enrique G. Mendoza, Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default, Federal Reserve Bank of Philadelphia, Working Papers 16-23, 09 Aug 2016.
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Keywords: Public debt; Sovereign default; European debt crisis
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