Financial frictions, default risk, and macroeconomic policy

This dissertation concerns the interaction between macroeconomic policies, financial frictions, and default risk. In Chapter 2 we study short- and long-run financial stability and macroeconomic outcomes in an economy where insolvent banks are bailed out by the government and an economy in which bank creditors are bailed in. We show that bailouts increase long run production, consumption, and credit supply with respect to the bail-in regime, while substantially increasing the fraction of banks that need to be recapitalized. In Chapter 3 we analyze how financial frictions in cross-border lending influence international capital flows and exchange rates. In addition, we investigate the effectiveness of imposing losses on foreign leverage-constrained banks when these banks lend to domestic leverage-constrained banks in foreign currency. We show that the presence of balance sheet constraints across borders leads to endogenous movements in capital flows and exchange rates. Furthermore, due to movements in exchange rates a write-down of foreign debt barely improves the capital position of domestic banks. Finally, in Chapter 4 I investigate the interaction between sovereign default risk and structural reforms at the zero lower bound in a monetary union. I find that sovereign default risk increases output losses after deflationary structural reforms when the economy is at the zero lower bound. Contractionary fiscal policy barely decreases sovereign default risk, while the positive spillovers of expansionary fiscal policy enacted in another country in the monetary union to the country that faces sovereign default risk are small.