What are potential macroeconomic consequences of a sovereign debt crisis in a small open economy?

• A. Lower interest rates, currency appreciation, default risk, inflation, and recession
• B. Higher interest rates, currency depreciation, default risk, inflation, and recession
• C. No impact on exchange rate
• D. Balanced budget with no inflation

Answer: (B)

When a small open economy faces a sovereign debt crisis, financing conditions tighten and the currency comes under pressure. Investors demand a larger risk premium to hold government debt, so borrowing costs rise. At the same time, doubts about repayment prompt capital to flow out, putting downward pressure on the currency and leading to depreciation. The government’s default risk increases as debt becomes harder to service, raising the likelihood that not all obligations will be timely paid. Depreciation makes imports more expensive, contributing to inflation, and the higher debt service burden, tighter credit, and weakened growth often push the economy into recession.

This combination—higher interest rates, a weaker currency, higher default risk, inflationary pressures, and a recession—is consistent with how a sovereign debt crisis typically unfolds in a small open economy. The other scenarios conflict with these dynamics: lower rates and currency appreciation don’t align with the risk and capital-flow pressures of a crisis; no exchange-rate impact ignores the real effects of finance and trade linkages; and a balanced budget with no inflation ignores the strain on debt and prices that crises usually bring.