Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

Abstract

Sovereign default is often associated with disturbances in a country’s trade relations. Often the defaulter’s currency depreciates while trade volume falls drastically. This paper develops a model to incorporate real depreciation along with sovereign bankruptcy. The exchange rate is determined in equilibrium as the relative price of imports. We demonstrate that a default episode can imply up to a 30% real depreciation. This matches the depreciations observed in crisis events for developing countries. We argue that much of the exchange rate movement is explained by market clearing adjustments to trade disruptions in the aftermath of default.