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Aggregate Demand and Sovereign Debt Crises

Sovereign debt crises are associated with pronounced recessions. In the conventional view, poor economic conditions increase default incentives and hence bond spreads. I provide evidence suggesting that the reaction of consumption demand creates feedback from sovereign spreads to output even while the government is in good standing with creditors. Because they ignore the savings behavior of private agents, existing models cannot capture this empirical feature of crises. I study the implications of this feedback mechanism in a model where the government of a small open economy borrows from foreign lenders but some of the debt is held by domestic savers who are heterogeneous in their wealth. This heterogeneity means that potential sovereign defaults carry redistributive effects in addition to aggregate income losses. Both of these effects introduce risk in private agents' expectations after bad news for repayment. Default risk then exacerbates the precautionary motive of households and depresses aggregate demand when spreads increase.