Welfare analysis of currency regimes with defaultable debts

Abstract

We modify the Cole and Kehoe model by including domestic debt. According to the original model, a speculative attack on a high debt level issued abroad triggers external debt default. Here, it is possible to inflate away the domestic debt to avoid the external debt default. We consider two possibilities for domestic debt denomination: (i) local currency and (ii) common currency. In the second case, inflation depends on a monetary union decision. Our numerical results show that to have a debt share denominated in a common currency is optimal when the refinancing risks are highly correlated across union members. Otherwise, the best is to keep the domestic debt denominated in local currency. Finally, the extreme case of having all debt issued abroad and denominated in a foreign currency is suitable when, under alternative regimes, suboptimal inflation motivated by political factors is likely. Although the paper was originally developed for emerging market economies, it sheds some light on the recent Eurozone crisis.