Document Type

Honors Project

Abstract

Sovereign debt crises have four consistent features: 1) financial crises tend to coincide with them; 2) they are followed by credit crunches; 3) the domestic costs of default are higher where financial institutions hold large portions of their sovereign's debt; and 4) sovereign risk premiums are countercyclical and exhibit nonlinear dynamics with respect to debt levels. These facts indicate that spillover between financial and debt crises are important means of amplifying economic downturns. Current models cannot replicate all four of these facts because they either lack investment, an endogenous fiscal limit on the accumulation of sovereign debt, or a nonlinear solution. I create a dynamic stochastic general equilibrium (DSGE) model with collateralized sovereign bonds used by entrepreneurs to obtain investment funds and an endogenous fiscal limit that instigates default. These two components are essential in explaining facts 1-3. I solve my model globally through the monotone map method so that it accurately matches the nonlinear behavior of sovereign risk premiums and accounts for fact 4. I calibrate my model to Spanish data from 1999- 2012 to test if it captures these four facts as well as the cyclical behavior of macroeconomic aggregates.

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Economics Commons

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