The Twin Ds: Optimal Default and Devaluation

A salient characteristic of sovereign defaults is that they are typically accompanied by large devaluations. This paper presents new evidence of this empirical regularity known as the Twin Ds and proposes a model that rationalizes it as an optimal policy outcome. The model combines limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default is shown to occur during contractions. The role of default is to free up resources for domestic absorption, and the role of exchange rate devaluation is to lower the real value of wages, thereby reducing involuntary unemployment.