Abstract: 

This paper develops a model to study how a default can affect the 
domestic economy and the government’s ability to provide liquidity. 
Banks that do not have good investment opportunities invest in public 
debt. After a default the government’s ability to credibly issue debt 
is undermined. A scarcer supply of public debt makes banks substitute 
away from government securities to investments in their less 
productive projects. A quantitative analysis of the model for 
Argentina can generate a deep and persistent fall in output 
post-default, which induces repayment incentives to sustain 
significant levels of external public debt. We provide empirical 
support for the model’s mechanism and use the model to analyze 
different policies that regulate banks’ holdings of public debt.