This dissertation consists of three chapters and is centered on the issues of external debt default and growth. In the first chapter, we develop a macrodynamic model of a small open economy that incorporates the effects of haircut and external debt default on the borrowing cost of a debtor country. We argue that the ability to impose a substantial haircut, a reduction in external debt in the face of a sovereign default can work as a strong enough incentive for a debtor country to borrow heavily even when it faces an increased default risk. Calibrating our model to real world data and employing numerical simulations we show that the observed overborrowing and consequently multiple external debt defaults by many countries around the world are equilibrium outcomes in the presence of the haircut induced benefit of sovereign default. Chapter two empirically investigates how debt default affects growth in low-income countries that have a high debt burden. We adopt Rose’s (2005) methodology of using dummy variables to examine both the contemporaneous and lagged effects of debt default on growth in countries that received debt relief assistance under the Heavily Indebted Poor Countries Initiative (HIPC). An inflow of capital is expected to affect these economies differently than other countries which are not eligible for the HIPC initiative. Our findings indicate that initiation of an external debt default leads to a downturn in growth, possibly due to the uncertainty created by such an event. However, debt renegotiation marking the conclusion of a default spell helps to revive growth and contributes to about 1 percentage point increase in growth for these countries. This positive growth effect of successful completion of a default episode is robust to different specifications and is pertinent even in the long run. In the third chapter, we examine the differential impacts of debt renegotiation on the various sectors within an economy. We analyze more than fifty years of data for ten broadly defined sectors from twenty-four mostly developing countries around the world. Our results indicate that debt rescheduling is associated with five to nine percent growth in sectoral productivity in countries outside of sub-Saharan Africa. This positive impact of debt renegotiation is particularly significant in the sectors of mining, construction, trade services, transport services, business services and personal services. Our findings provide support to the postulations of the debt overhang theory and the crowding out theory at sectoral level.

In my first chapter I follow the methodology put forth by Bohn(1998), the market-based sustainability method to measure whether the sovereign debt is sustainable or not. I work with a panel of 125 countries for 26 years and along with incorporate different institutions ratings by ICRG’s political risk ratings. In my analysis I find out that the debt on average is sustainable for countries up to certain extent and thus giving us an inverted U shape debt-exports curve. I use country exports to find out if the debt is sustainable or not. I also find that better institutions do give an edge to countries when it comes to borrowing as it lowers the risk expectations on the lenders part. The findings do vary based on the country’s income level and based on its geographical location.

Essay 1: Expectation-Driven House Prices, Debt Default and Inflation Dynamics We contribute to the literature on dynamic stochastic general equilibrium (DSGE) models with housing collateral by including shocks to house price expectations. We also incorporate endogenous mortgage defaults that are rarely included in DSGE models with housing collateral. We use this model to study the effects of variations in house price expectations on macroeconomic dynamics and their implications for monetary policy. Model simulations show that an increase in expected future house prices leads to a decline in mortgage default rate and interest rates on household and business loans, whereas it leads to an increase in house prices, housing demand, household debt, business debt, bank leverage ratio and economic activity. In contrast to previous studies, we find that inflation is low during a house price boom. Finally, we show that monetary policy that takes into account household credit growth reduces the volatility of output and dampens a rise in housing demand, household debt and bank leverage ratio that enhances financial stability. However, a central bank that reacts to household credit growth increases the volatility of inflation. / Essay 2: House Price Expectations, Boom-Bust Cycles and Implications for Monetary Policy This essay examines the role of household expectations about future house prices and their implications for boom-bust cycles and monetary policy. Our findings are as follows. First, waves of optimism and pessimism about future house prices generate boom-bust cycles in house prices, financial activities (household debt, business debt, bank leverage, interest rates on household and business loans) and the real economy (housing demand, consumption, employment, investment and output). Second, we find that inflation declines during a house price boom and increases during a house price burst. Third, we find that monetary policy that reacts to household credit growth reduces the magnitude of boom-bust cycles and improves household welfare. Fourth, we find that the case for taking into account household credit growth becomes stronger in an economy in which the bank capital to asset ratio requirement is low, interest rates on loans and deposits adjust immediately to changes in the policy rate, or the household sector is highly indebted. / Essay 3: Credit Disruptions and the Spillover Effects between the Household and Business Sectors This essay examines the effects of credit supply disruptions in a New Keynesian DSGE model with housing collateral and working capital channels. A tightening of business credit conditions creates negative spillovers from the business sector to the household sector through labor income and housing collateral channels. A tightening of household credit conditions has negative spillover effects on the business sector via the housing collateral channel. We find that spillovers are more sensitive to changes in leverage where the shock occurs. A negative business credit shock creates upward pressure on inflation, whereas a negative household credit shock creates downward pressure on inflation. The working capital channel magnifies the response of inflation to a business credit shock, whereas it dampens the response of inflation to a household credit shock.