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Abstract

I extend the baseline framework used in quantitative studies of sovereign default by explicitly modeling a domestic financial sector and by allowing the government to force financial intermediaries to hold government debt on their balance sheets. Default is more costly when the government uses financial repression to increase domestic holdings of debt because it inhibits the flow of resources from savers to firms. Financial repression is costly because it reduces the accumulation of net worth of the banking sector. It is an imperfect commitment device as sufficiently bad shocks can lead to a default. A quantitative analysis of the model for Argentina shows that default that happens despite financial repression results in a deep and persistent output loss. Financial repression is usually used when the level of international interest rate is high and its absence results in large welfare losses.

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