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Default and Interest Rate Shocks: Renegotiation Matters

Working Paper 806 | Published June 17, 2024

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Authors

Victor Almeida Carleton College
Carlos Esquivel Rutgers University
Timothy J. Kehoe Consultant, University of Minnesota, and National Bureau of Economic Research
Juan Pablo Nicolini Senior Research Economist and Universidad Torcuato Di Tella
Default and Interest Rate Shocks: Renegotiation Matters

Abstract

We develop a sovereign default model with debt renegotiation in which interest-rate shocks affect default incentives through two mechanisms. The first mechanism, the standard mechanism, depends on how a higher interest rate tightens the government’s budget constraint. The second mechanism, the renegotiation mechanism, depends on how a higher rate increases lenders’ opportunity cost of holding delinquent debt, which makes lenders accept larger haircuts and makes default more attractive for the government. We use the model to study the 1982 Mexican default, which followed a large increase in U.S. interest rates. We argue that our novel renegotiation mechanism is key for reconciling standard sovereign default models with the narrative that U.S. monetary tightening triggered the crisis.