The Macrodynamic Effects of Alternative Resolution Strategies for Debtor Countries

Abstract

This paper examines the macrodynamic effect of alternative resolution strategies of indebted nations through simulation analysis. We examine the macrodynamic implications of continued debt servicing, debt forgiveness and a debt/equity swap in a model which includes staggered contracts, rational expectations, a devaluation rule based on current account targets and endogenous government spending dependent upon the wage and exchange rate levels. Our analysis shows that debt/equity swaps induce greater instability in the subsequent macroeconomic adjustment process than simple debt forgiveness or continued debt servicing outcomes or resolutions to the debt problem.

The analysis is based on an open-economy, general equilibrium, rational expectations macroeconomic model with overlapping contracts or staggered wage setting. We introduce the spread of nominal wages as a relevant macroeconomic variable, and thus draw attention to a trade-off not accounted for in previous models. Higher wage dispersion may cause output losses (through more frequent contract negotiation and work stoppages), prolong business cycles, and increase its volatility. The paper shows that the long-term effects of debt/equity swaps, which increase wage dispersion more than other strategies, may be less desirable than what conventional models, which by and large have ignored these effects, may lead us to believe.