The Welfare Cost of Sovereign Default and Liquidity Injections

This paper develops a dynamic general equilibrium model with endogenous default on entrepreneur loans and funds borrowed from the central bank (liquidity injections) and investigates the welfare cost of sovereign default. The results show that sovereign default affects production through households’ investment decisions and the bank’s asset portfolio adjustment. The effect of sovereign default on entrepreneurs tends to be in favor of production. Sovereign default reduces the variability of the output gap and hence the welfare loss. Liquidity injections reduce the variability of the output gap and improve price stability during the period of sovereign debt crisis, resulting in an increase in households’ welfare.