Abstract

A model of interest rates on sovereign bonds with default risk is presented. The model accounts for interaction between interest rates and default risk. Multiple equilibria and stability issues are examined. The model explores the level of debt that markets will tolerate in a context where there is uncertainty about output growth, fiscal discipline, real exchange rates, and IMF intervention. The effect of likely IMF assistance on the debt ceiling is shown to be large.

Keywords: Default risk; Moral hazard; Sovereign debt

JEL classification codes: F3 International Finance–H6 National Budget; Deficit; Debt–G0 Financial Economics: General