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

Abstract

The continuing debt crisis that many developing countries have faced in the current decade has underscored the need to understand the relationships between debt accumulation and growth, as well as the need to develop policy approaches that foster adjustment in the external account while maintaining the growth of output. The purpose of this paper is to develop a macroeconomic model for a small open developing economy that borrows abroad. This model will assist in studying the dynamic interaction between debt and growth, as well as the impact of various policies and exogenous shocks on the rate of capital accumulation, the current account and debt. From this analysis, the authors make the following conclusions. An upward shift in the supply of debt leads to a long run decline in external debt, a higher domestic interest rate, less capital stock, and a reduced trade surplus. An increase in the marginal cost of debt may or may not lower long run external debt as well. An increase in productivity raises the long run stock of capital but leaves the level of external debt and the interest rate unchanged in the long run. Finally, fiscal expansion has almost no effect in either the short run or the long run.