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Uncertainty shocks and non-fundamental debt crises: An ambiguity approach

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  • Große Steffen, Christoph
Abstract
This paper analyses empirically and theoretically the effects of uncertainty shocks on sovereign default risk. It describes a novel mechanism for non-fundamental debt crises induced by uncertainty shocks that are defined as time-varying levels of ambiguity surrounding the macroeconomic fundamental of the economy. A business cycle model with strategic sovereign default is augmented with ambiguity averse investors with multiple-priors utility. I find that uncertainty shocks increase the risk of default as perceived by worst case investors' beliefs. Sovereign and private sector interest rates rise due to a spillover channel that unfolds through the domestic banking sector. A crisis zone is characterised where worst case investors' beliefs lead to non-fundamental debt crises. The model's predictions are shown to be in line with impulse responses obtained from a VAR analysis for a panel of four Euro area countries. Specifically, the dichotomy of sovereign debt pricing in the core and periphery countries can partly be rationalised by accounting for ambiguity premia.

Suggested Citation

  • Große Steffen, Christoph, 2015. "Uncertainty shocks and non-fundamental debt crises: An ambiguity approach," VfS Annual Conference 2015 (Muenster): Economic Development - Theory and Policy 112936, Verein für Socialpolitik / German Economic Association.
    • Handle: RePEc:zbw:vfsc15:112936
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    Cited by:

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    4. Christoph Große Steffen & Maximilian Podstawski, 2016. "Ambiguity and Time-Varying Risk Aversion in Sovereign Debt Markets," Discussion Papers of DIW Berlin 1602, DIW Berlin, German Institute for Economic Research.

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    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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