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American Economic Review: Vol. 98 No. 3 (June 2008)

AER Volume. 98, Issue 3 | Previous ArticleNext Article

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Default Risk and Income Fluctuations in Emerging Economies

Article Citation

Arellano, Cristina. 2008. "Default Risk and Income Fluctuations in Emerging Economies." American Economic Review, 98(3): 690-712.

DOI: 10.1257/aer.98.3.690

Abstract

Recent sovereign defaults are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default is more likely in recessions because this is when it is more costly for a risk averse borrower to repay noncontingent debt. The model closely matches business cycles in Argentina predicting high volatility of interest rates, higher volatility of consumption relative to output, and negative correlations of output with interest rates and the trade balance.

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Authors

Arellano, Cristina (U MN and Federal Reserve Bank of Minneapolis)

JEL Classifications

E32: Business Fluctuations; Cycles
E43: Determination of Interest Rates; Term Structure of Interest Rates
F34: International Lending and Debt Problems
O11: Macroeconomic Analyses of Economic Development
O19: International Linkages to Development; Role of International Organizations