Growth, External Debt, and Sovereign Risk in a Small Open Economy

An optimizing growth model for a highly indebted small open economy is constructed and analyzed. An important innovation in the model is the incorporation of sovereign risk through the specification of an upward-sloping foreign debt supply function. The model is used to examine the interaction between external debt and growth in response to various policies and exogenous disturbances. It is shown that structural policies intended to reduce the fiscal deficit or increase productivity can lead to trade-offs in their effect on capital accumulation and the stock of debt.