Unemployment and Debt Dynamics in a Highly Indebted Small Open Economy

33 Pages Posted: 29 Jun 2011

See all articles by Burkhard Heer

Burkhard Heer

University of Augsburg; CESifo (Center for Economic Studies and Ifo Institute)

Stefan Franz Schubert

Free University of Bozen-Bolzano

Date Written: June 28, 2011

Abstract

The paper analyzes the dynamic effects of a total factor productivity shock and an interest rate risk premium shock in a highly indebted open economy. In contrast to the standard open economy framework, search unemployment and wage bargaining are introduced. We find that a negative total factor productivity shock primarily has effects on the economy’s production side and on welfare, but not on its stock of foreign debt and the country specific risk premium, and large part of the adjustment happens in the short run. In contrast, a pure increase in the country specific risk premium causes substantial dynamics and a considerable reduction in foreign debt, allowing higher consumption in the long run and creating an intertemporal welfare gain, even though unemployment increases strongly in the short run. A 50% haircut of foreign debt significantly reduces the initial response of the unemployment rate. In case of a temporary productivity shock, sticky wages imply smaller employment, but generate higher welfare than flexible wages.

Keywords: unemployment, debt, interest rate premium, haircut, sticky wages

JEL Classification: F340, F410, J640

Suggested Citation

Heer, Burkhard and Schubert, Stefan Franz, Unemployment and Debt Dynamics in a Highly Indebted Small Open Economy (June 28, 2011). CESifo Working Paper Series No. 3497, Available at SSRN: https://ssrn.com/abstract=1873870

Burkhard Heer (Contact Author)

University of Augsburg ( email )

Universitätsstr. 2
Augsburg, 86159
Germany

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

Stefan Franz Schubert

Free University of Bozen-Bolzano ( email )

Via Sernesi 1
39100 Bozen-Bolzano (BZ)
Italy
+390471013495 (Phone)

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