Seunghoon Na, Stephanie Schmitt-Grohé, Martin Uribe, and Vivian Yue
CQER Working Paper 15-01
April 2015
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This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages, thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. In contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have stronger default incentives and therefore support less external debt than economies with optimally floating rates.
JEL classification: E43, E52, F31, F34, F38, F41
Key words: sovereign default, exchange rates, optimal monetary policy, capital controls, downward nominal wage rigidity, currency pegs
Stephanie Schmitt-Grohé and Martin Uribe thank the National Science Foundation for research support. For comments, we thank Javier Bianchi, Robert Kollmann, and seminar participants at the University of Bonn, Columbia University, Harvard University, Seoul National University, the European Central Bank, the Federal Reserve Bank of Philadelphia, Massachusetts Institute of Technology, the Board of Governors, the CIREQ-ENSAI workshop, the Cornell PSU conference, and the International Finance and Macroeconomics October 2014 program meeting of the National Bureau of Economic Research. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Seunghoon Na, Department of Economics, Columbia University, 420 W. 118th Street, MC 3308, New York, NY 10027, sn2518@columbia.edu; Stephanie Schmitt-Grohé, Columbia University, CEPR, and NBER, Department of Economics, Columbia University, 420 W. 118th Street, MC 3308, New York, NY 10027, 212-851-4010, stephanie.schmittgrohe@columbia.edu; Martin Uribe, Columbia University and NBER, Department of Economics, Columbia University, 420 W. 118th Street, MC 3308, New York, NY 10027, 212-851-4008, martin.uribe@columbia.edu; or Vivian Yue, Emory University and Federal Reserve Bank of Atlanta, Department of Economics, Emory University, Rich Memorial Building, Room 306, Atlanta, GA 30322-2240, 404-727-0340, vivianyue1@gmail.com.
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