Devaluation, Debt, and Default in Emerging Economies

We explore the interactions between exchange rate and fiscal policy, and default on external debt. Exchange rate policy affects the supply of short-term debt facing the government. Under a conventional soft peg, it can be optimal for the government to set the exchange rate at a level in which partial default occurs. In this case multiple equilibria exist, with one featuring high interest rate, overvalued exchange rate, low level of output, and default. Default is also an equilibrium under a hard peg, precisely because devaluation is not an option. Under a hard peg, however, there is a unique equilibrium. Copyright Springer Science+Business Media, LLC 2007