A Model of the Twin DS: Optimal Default and Devaluation

This paper characterizes jointly optimal default and exchange-rate policy. The theoretical environment is a small open economy with downward nominal wage rigidity as in Schmitt-Grohe and Uribe (2013) and limited enforcement of international debt contracts as in Eaton and Gersovitz (1981). It is shown that under optimal policy default is accompanied by large devaluations. At the same time, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are found to be able to support less external debt than economies with optimally floating rates. In addition, the following three analytical results are presented: 1) Real economies with limited enforcement of international debt contracts in the tradition of Eaton and Gersovitz (1981) can be decentralized using capital controls; 2) Real economies in the tradition of Eaton and Gersovitz can be interpreted as the centralized version of models with downward nominal wage rigidity, optimal capital controls, and a full-employment exchange-rate policy; and 3) Full-employment is optimal in an economy with downward nominal wage rigidity, limited enforcement of debt contracts, and optimal capital controls.