Welfare gains of bailouts in a sovereign default model

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Title: Welfare gains of bailouts in a sovereign default model
Author: Pancrazi, Roberto ; Seoane, Hernán D. ; Vukotic, Marija
Organization: Bank of Finland
Series: Bank of Finland Research Discussion Papers
ISSN: 1456-6184
Series year: 2019
Series number: 25/2019
Year of publication: 2019
Publication date: 18.12.2019
Pages: 42
Subject (yso): valtionvelka; riskit; maksukyvyttömyys; lainat (rahasumma)
Keywords: maksuvaikeudet; hyvinvointivaikutukset
JEL: E44; F32; F34
Other keywords: Default; Sovereign Risk; Bailouts
Abstract: We examine the welfare effects of bailouts in economies exposed to sovereign default risk. When a government of a small open economy requests a bailout from an international financial institution, it receives a non-defaultable loan of size G that comes with imposed debt limits. The government endogenously asks for the bailout during recessions and repays it when the economy recovers. Hence, the bailout acts as an imperfect state contingent asset that makes the economy better off. The bailout duration is endogenous and increases with its size. The bailout size creates non-trivial tradeoffs between receiving a larger amount of relatively cheap resources precisely in times of need on the one hand, and facing longer-lasting financial constraints and accumulated interest payments, on the other hand. We characterize and quantify these tradeoffs and document that welfare gains of bailouts are hump-shaped in the size of bailout loans.
Rights: https://helda.helsinki.fi/bof/copyright

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