On the Effects of Sovereign Debt Volatility: a Theoretical Model

Economics master project by Oscar Fernández, Sergio Fonseca, Gino Magnini, Riccardo Marcelli Fabiani, and Claudia Nobile

Two pairs of hands exchange euro bills
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Editor’s note: This post is part of a series showcasing BSE master projects. The project is a required component of all Master’s programs at the Barcelona School of Economics.

Abstract

We construct a theoretical Overlapping Generations (OLG) model to describe how sovereign debt crises can propagate in the economy under certain financial constraints.

In the model, households work when young and deposit their savings in exchange for a dividend, banks invest deposits in assets and government bonds. Banks, subject to legal and market requirements, invest a fixed fraction of deposits and own equity in assets. When prices of bonds fall due to perceived sovereign debt risks, banks can invest less on capital goods directly affecting the business cycle. This paper simulates the deviations from steady-state produced by a shock to government securities and provides insights into macro-prudential policy implications.

We find that a sovereign debt crisis affects young and old generations differently, with the latter facing higher fluctuations in consumption. We also find that the macro-prudential policy can be effective only at very high levels on the old, but ineffective for the younger generation.

Conclusions

This paper draws three main conclusions about the impact of a sovereign debt crisis on the business cycle within the proposed OLG theoretical framework:

  1. A decline in government bond prices leads to lower output, wages and dividend negatively affecting present and future consumption. However, this effect is different for young and old generations. In particular, the old seem to face more sudden changes and higher deviations from steady-state values when a sovereign debt crisis takes place.
  2. The proposed macro-prudential policy does not seem to offset the impact of a fall in government bonds prices on the business cycle. In fact, almost all the macroeconomic variables of interest in our theoretical model do not change significantly, relative to their steady-state values, when the supervising authority modifies the capital requirements for banks.
  3. A very aggressive policy on capital requirements (i.e. x=0.9 for the whole period) can compensate for the negative shock bonds prices have on dividends and, therefore, consumption for the old.

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