DP10697 A Model of the Twin Ds: Optimal Default and Devaluation

Author(s): Seunghoon Na, Stephanie Schmitt-Grohé, Martín Uribe, Vivian Yue
Publication Date: July 2015
Keyword(s): capital controls, currency pegs, downward nominal wage rigidity, exchange rates, optimal monetary policy, sovereign default
JEL(s): E43, E52, F31, F34, F38, F41
Programme Areas: International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10697

This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. By contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have stronger default incentives and therefore support less external debt than economies with optimally floating rates.