Conferences at Department of Economics, University of Toronto, RCEF 2012: Cities, Open Economies, and Public Policy

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Sovereign Defaults and Interest Rate Spread in the Presence of Self Control Problem

Li Li*

Last modified: 2012-07-23


Arellano (2008) studies sovereign defaults in emerging markets, but has trouble to match the large interest rate spread, especially during the boom episodes. It brings the problem that her paper artificially generates the crisis in bad shock by giving up the fact the interest rate spread is high in good time. If Arellano correctly calibrates her model by improving the missing part of interest rate spread in good state, she needs extremely low output level in order to generate the high default risk in bad state. However, such an extremely low output level has not yet been observed in the data. This paper introduces self-control preferences into a standard Arellano (2008) theoretical framework to study default risk and its interaction with output, consumption, and foreign debt. I make two sets of contributions. First, I correctly generate the default risk when bad shock happens, which is incorrectly calculated in Arellano (2008). Second, I capture the missing part of the interest spread before crisis which Arellano is not able to get in her calibration.