Equilibrium Default Cycles

Posted: 20 Dec 2007

See all articles by Natalia Kovrijnykh

Natalia Kovrijnykh

University of Chicago - Department of Economics

Balázs Szentes

University of Chicago - Department of Economics

Abstract

This paper analyzes Markov equilibria in a model of strategic lending in which (i) agents cannot commit to long-term contracts, (ii) contracts are incomplete, and (iii) incumbent lenders can coordinate their actions. Default cycles occur endogenously over time along every equilibrium path. After a sequence of bad shocks, the borrower in a competitive market accumulates debt so large that the incumbent lenders exercise monopoly power. Even though the incumbents could maintain this power forever, they find it profitable to let the borrower regain access to the competitive market after a sequence of good shocks. Equilibria are computed numerically, and their attributes are qualitatively consistent with numerous known empirical facts on sovereign lending. In addition, the model predicts that a borrower who accumulates debt overhang will regain access to the competitive credit market only after good shocks. This prediction is shown to be consistent with data on emerging market economies.

Suggested Citation

Kovrijnykh, Natalia and Szentes, Balázs, Equilibrium Default Cycles. Journal of Political Economy, Vol. 115, No. 3, 2007, Available at SSRN: https://ssrn.com/abstract=1076566

Natalia Kovrijnykh

University of Chicago - Department of Economics ( email )

1126 East 59th Street
Chicago, IL 60637
United States

Balázs Szentes (Contact Author)

University of Chicago - Department of Economics ( email )

1126 East 59th Street
Chicago, IL 60637
United States
(773) 702-9127 (Phone)

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