Weekly Economics Webinar by Francisco Roldan
September 2 @ 6:30 pm - 7:40 pm
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Title: The Aggregate-Demand Doom Loop: Precautionary Motives and the Welfare Costs of Sovereign Risk [link to paper]
Speaker: Francisco Roldan, Economist Program – Research Department, IMF
Abstract: Sovereign debt crises coincide with deep recessions. In the conventional view, poor economic conditions increase default incentives, and bond spreads. I provide evidence suggesting that the reaction of consumption demand creates feedback from sovereign spreads to output even while the government is in good standing with creditors. Because they ignore the savings behavior of private agents, existing models cannot capture this empirical feature of crises. I study the implications of this feedback mechanism in a model where the government of a small open economy borrows from foreign lenders but some of the debt is held by heterogeneous domestic savers. Because of this heterogeneity in wealth, potential sovereign defaults carry redistributive effects besides aggregate income losses. Both effects introduce risk in private agents’ expectations upon bad news for repayment. Default risk then exacerbates the precautionary motive of households and depresses aggregate spending. In a calibration to Spain in the 2000s, I find that about 30% of the output contraction is attributable to default risk. More generally, sovereign risk exacerbates volatility in consumption, creating large welfare losses even if default does not materialize.