Macroeconomics and Finance

This paper studies how sovereign default can affect productivity and output, using a continuous-time model in which the government chooses whether to service its debt and default changes the future productivity process. The model is calibrated with financial-market information for ten European countries during 2009–2012, when stock prices and sovereign risk premiums moved inversely. For a pooled, representative country, the calibration implies that markets price in a 3.70% decline in total factor productivity; averaging country-specific estimates yields a 5.88% decline. The model predicts an output contraction of about 3.71% for a typical debt crisis. The authors use the framework to examine crisis dynamics, recovery, fiscal policy, and how default incentives vary with initial debt.

The authors develop a framework for optimal policy by an inflation-targeting central bank that is uncertain about its model and whose degree of mistrust changes as the economy’s structure changes. Structural breaks and price, output, or real-exchange-rate shocks can alter the perceived uncertainty. Robust control represents policymakers’ uncertainty aversion, while a Markov chain captures changes in that aversion over time. The analysis finds that a more aggressive interest-rate response is generally optimal when policymakers are more uncertainty-averse or when future uncertainty aversion is more likely. Greater uncertainty aversion also lowers policymakers’ welfare. The effects of the Markov transition probabilities on expected losses are ambiguous, showing that the timing and persistence of uncertainty can complicate monetary-policy decisions.