Default Risk, Sectoral Reallocation and Persistent Recessions

Abstract: 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 reducing investment and reallocating capital toward the traded sector to support debt service payments. The real exchange rate depreciates, a re?ection of the scarcity of traded goods. We ?nd that these mechanisms are quantitatively important for rationalizing the experience of Spain during the recent debt crisis.

Keywords: Traded and nontraded production; Sovereign default with production economy; Capital accumulation; Real exchange rate; European debt crisis;

JEL Classification: F30; E30;

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Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Staff Report

Publication Date: 2017-09-13

Number: 555

Pages: 37 pages