Question

Suppose we have an emerging economy with a current GDP of $120 billion. It borrows $20 billion which it plans to repay next year. The costs of default are 20% of GDP. Consider 2 scenarios:

Scenario A: GDP next period is $120 billion - the real interest rate is 10%

Scenario B: GDP next period is $110 billion - the real interest rate is 20%

a) (10 points) Assuming scenario A, is it in the best interest of this emerging economy to pay its debt or default? Show all work and explain.

b) (20 points) Now draw a repayment vs. default diagram with consumption on the vertical axis and GDP on the horizontal axis (as in the textbook and lecture). Assuming scenario A, label this point as point A. Similarly, assuming scenario B, label this as point B. Be sure your diagram is completely labeled with a consumption if you default line, a consumption if you pay line, slopes labeled as well as repayment threshold level of GDP (YT) and the default / repayment zones. Please show your work calculating YT.

c) (10 points) Assuming scenario B, is it in the best interest of this emerging economy to pay its debt or default? Show all work and explain.

d) (20 points) Now draw a repayment vs. default diagram with consumption on the vertical axis and GDP on the horizontal axis (as in the textbook and lecture). Assuming scenario A, label this point as point A. Similarly, assuming scenario B, label this as point B. Be sure your diagram is completely labeled with a consumption if you default line, a consumption if you pay line, slopes labeled as well as repayment threshold level of GDP (YT) and the default / repayment zones. Please show your work calculating YT.

e) (10 points) Explain the intuition (the economics) as to why your decision to default/repay changed from scenario A to scenario B.

f) (10 points) Name all the factors that you can think of that would lower the repayment threshold level of GDP (YT) and the intuition as to why each factor would lower YT.

Answer 1

Most countries issue debt involves to finance their growth. Emerging economy can be at the disadvantage when it comes to borrowing funds. Like investors with poor credit, emerging economies have to pay higher interest rate and issue debt in foreign stronger currencies to offset the additional risk assumed by the investor. Problems can arise when inexperienced goverments overvalue the project to be funded by the debt, overestimate the revenue that will be generated by economic growth, structure their debt in such a way as to meke paymwnts only feasible in the best of economic circumstances or if exchange rates make payments in the denominated currencytoo difficult. Most of the debt

stock owned by d emerging economies are denominated in foreign currency.Even a small increase in interest rate is likely to cause a shock waves across d emerging economy.