This paper studies an optimal renegotiation protocol designed by a benevolent planner when two countries renegotiate with the same lender. The solution calls for recoveries that induce each country to default or repay, trading off the deadweight costs and the redistribution benefits of default independently of the other country. This outcome contrasts with a decentralized bargaining solution where default in one country increases the likelihood of default in the second country because recoveries are lower when both countries renegotiate. The paper suggests that policies geared at designing renegotiation processes that treat countries in isolation can prevent contagion of debt crises.

This paper formalizes a classic idea that in second-best environments trade can induce welfare losses: incremental income losses from distortions can outweigh trade gains. In a Melitz model with distortionary taxes, we derive sufficient statistics for welfare gains/losses and show departures from the efficient case (Arkolakis, Costinot, and Rodríguez-Clare 2012) can be captured by the gap between an input and output share and domestic extensive margin elasticities. The loss reflects an endogenous selection of more subsidized firms into exporting. Using Chinese manufacturing data in 2005 and model-inferred firm-level distortions, we demonstrate that a sizable negative fiscal externality can potentially offset conventional gains.

We pose good markets frictions on top of an otherwise standard two-country international real business cycle (IRBC) model. Shopping for goods takes effort, which prevents perfect matching between customers and producers. An increase in search effort implies increased measured productivity. Demand shocks increase expenditures and search effort simultaneously increasing output, consumption, productivity, and the trade deficit and appreciating the real exchange rate. Thus we solve the Backus-Smith puzzle and we show that the cross country correlation of consumption is higher than that of output. Standard IRBC models cannot account for these puzzles along with movements in TFP.