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Pareto Improving Fiscal and Monetary Policies: Samuelson in the New Keynesian Model
This paper explores the positive and normative consequences of government bond issuances in a New Keynesian model with heterogeneous agents, focusing on how the stock of government bonds affects the cross-sectional allocation of resources in the spirit of Samuelson (1958). We characterize the Pareto optimal levels of government bonds and the associated monetary policy adjustments that should accompany Pareto-improving bond issuances. The paper introduces a simple phase diagram to analyze the global equilibrium dynamics of inflation, interest rates, and labor earnings in response to changes in ...
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Dollarization and financial integration
How does a country's choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization. ; We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can ...
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Fiscal Austerity during Debt Crises
This paper constructs a dynamic model in which fiscal restrictions interact with government borrowing and default. The government faces fiscal constraints; it cannot adjust tax rates or impose lump-sum taxes on the private sector, but it can adjust public consumption and foreign debt. When foreign debt is sufficiently high, however, the government can choose to default to increase domestic public and private consumption by freeing up the resources used to pay the debt. Two types of defaults arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because of the ...
Working Paper
External and Public Debt Crises
The recent debt crises in Europe and the U.S. states feature similar sharp increases in spreads on government debt but also show important differences. In Europe, the crisis occurred at high government indebtedness levels and had spillovers to the private sector. In the United States, state government indebtedness was low, and the crisis had no spillovers to the private sector. We show theoretically and empirically that these different debt experiences result from the interplay between differences in the ability of governments to interfere in private external debt contracts and differences in ...
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Financial frictions and fluctuations in volatility
During the recent U.S. financial crisis, the large decline in economic activity and credit was accompanied by a large increase in the dispersion of growth rates across firms. However, even though aggregate labor and output fell sharply during this period, labor productivity did not. These features motivate us to build a model in which increased volatility at the firm level generates a downturn but has little effect on labor productivity. In the model, hiring inputs is risky because financial frictions limit firms' ability to insure against shocks that occur between the time of production and ...
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Sovereign risk and firm heterogeneity
This paper studies the recessionary effects of sovereign default risk using firm-level data and a model of sovereign debt with firm heterogeneity. Our environment features a two-way feedback loop. Low output decreases the tax revenues of the government and raises the risk that it will default on its debt. The associated increase in sovereign interest rate spreads, in turn, raises the interest rates paid by firms, which further depresses their production. Importantly, these effects are not homogeneous across firms, as interest rate hikes have more severe consequences for firms that are in need ...
Working Paper
Dollarization and financial integration
How does a country?s choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization. We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can strengthen ...
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Deadly Debt Crises: COVID-19 in Emerging Markets
The COVID-19 epidemic in emerging markets risks a combined health, economic, and debt crisis. We integrate a standard epidemiology model into a sovereign default model and study how default risk impacts the ability of these countries to respond to the epidemic. Lockdown policies are useful for alleviating the health crisis but they carry large economic costs and can generate costly and prolonged debt crises. The possibility of lockdown induced debt crises in turn results in less aggressive lockdowns and a more severe health crisis. We find that the social value of debt relief can be ...
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Default Risk, Sectoral Reallocation and Persistent Recessions
Sovereign debt crises are associated with large and persistent declines in economic activity, disproportionately so for nontradable sectors. This paper documents this pattern using Spanish data and builds a two-sector dynamic quantitative model of sovereign default with capital accumulation. Recessions are very persistent in the model and more pronounced for nontraded sectors because of default risk. An adverse domestic shock increases the likelihood of default, limits capital in?ows, and thus restricts the ability of the economy to exploit investment opportunities. The economy responds by ...
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Appendix for Financial Frictions and Fluctuations in Volatility
This appendix contains five sections. Section 1 provides details for the comparative statics exercise performed in the simple example. Section 2 discusses extending the model to allow firms to default on the wages for managers. Section 3 describes the firm-level and aggregate data. Section 4 contains the details of the computational algorithm. Finally, Section 5 reports the results for our model with a lower labor elasticity.