NBER WORKING PAPER SERIES A SOLUTION TO THE DISCONNECT BETWEEN COUNTRY RISK AND BUSINESS CYCLE THEORIES. Enrique G. Mendoza Vivian Z.

Transcription

1 NBER WORKING PAPER SERIES A SOLUTION TO THE DISCONNECT BETWEEN COUNTRY RISK AND BUSINESS CYCLE THEORIES Enrique G. Mendoza Vivian Z. Yue Working Paper NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA March 2008 We thank Cristina Arellano, Andy Atkeson, Fernando Broner, Jonathan Eaton, Jonathan Heathcote, Olivier Jeanne, Pat Kehoe, Tim Kehoe, Narayana Kocherlakota, Guido Lorenzoni, Andy Neumeyer, Fabrizio Perri, Victor Rios-Rull, Tom Sargent, Stephanie Schmitt-Grohe, Martin Uribe, and Mark Wright for helpful comments and suggestions. We also acknowledge comments by participants at seminars and conferences at Paris School of Economics, NYU, CUNY, the Federal Reserve Banks of Kansas City and Minneapolis, SUNY-Albany, Duke University, Univ. of Texas-Austin, Ohio State University, 2007 SED Annual Meeting, 2007 LACEA Annual Meeting, the CREI-CEPR 2007 Conference on Sovereign Risk, the X Workshop in International Economics and Finance at Di Tella University, the 2008 IEA World Congress and the 2008 NBER Summer Institute. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research by Enrique G. Mendoza and Vivian Z. Yue. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source.

2 A Solution to the Disconnect between Country Risk and Business Cycle Theories Enrique G. Mendoza and Vivian Z. Yue NBER Working Paper No March 2008, Revised April 2010 JEL No. E32,E44,F32,F34 ABSTRACT We propose a model that solves the crucial disconnect between business cycle models that treat default risk as an exogenous interest rate on working capital, and sovereign default models that treat output fluctuations as an exogenous process with ad-hoc default costs. The model explains observed output dynamics around defaults, countercyclical spreads, high debt ratios, and key business cycle moments. Three features of the model are central for these results: working capital loans pay for imported inputs; default triggers an efficiency loss as imported inputs are replaced by imperfect domestic substitutes; and default on public and private foreign obligations occurs simultaneously. Enrique G. Mendoza Department of Economics University of Maryland College Park, MD and NBER mendozae@econ.umd.edu Vivian Z. Yue Department of Economics 19 West 4th Street New York University New York, NY zy3@nyu.edu

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18 Interest Rate Interest Rate Interest Rate Interest Rate Interest Rate Interest Rate 80 Argentina 9 Chile 12 Malaysia Year Mexico Year Year Peru Year Year Thailand Year

19

20 a. Total intermediate goods (M) b. Imported intermediate goods (m*) c. Domestic intermediate goods (md) d. Labor supply (L) e. Labor in final goods sector (Lf) 1 f. Labor in intermediate goods (Lm) Baseline(3.23) Baseline w. inelastic labor(3.23) Threshold elasticity(1.93) Cobb-Douglas(1)

21

22 GDP Cost Output Costs of Default as a Function of TFP Shock log of TFP shock Elasticity=3.23 (left axis) Threshold Elasticity=1.93 (right axis) GDP Cost

23 percent GDP drop at default Output costs of default for a neutral TFP shock at different elasticities of substitution Elasticity of substitution between foreign and domestic w S L * w w ~ B B ~ A~ A D D L = L f + L D m L ~ f * L f D L m ~ D D L L f + = ~ L D m * L m L ~ m L ~ * L L, L f, L m

24

25

26

27

28

29

30 10 GDP deviation (Percentage) GDP data "Simulated GDP" "Simulation One Std. Error Band" Simulated GDP with Reaccess Simulated GDP in Exclusion

31

32 Solow Residual True TFP GDP

33 Spread (Percentage) Simulated Spread Simulated GDP GDP Deviation (Percentage) Spread (Percentage) Spread Data GDP data GDP Deviation (Percentage) consumption debt-output ratio current account-output ratio labor

34 labor in f inal sector labor in intermediate sector intermediate goods

35

36

37 Benchmark No Working Capital Benchmark Larger WC

38

39 Benchmark Lower Elasticity Lower md Weight Lower Labor Elasticity

40

41

42

43

44

45

46