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The purpose of this paper is to emphasize the importance of credit risk in a model that integrates the determination of international lending and exchange rates. The literature on exchange rate determination contains a number of models that integrate an equilibrium condition on stocks of assets or debts with an equilibrium condition on goods flows or the international trade balance; together, these conditions anchor the (long-run) level of the real exchange rate, defined either as a relative price of domestic and foreign goods or relative price of nontradable and tradable goods. Models of this type include DOrnbusch, Calvo and Rodriguez, Dornbusch and Fischer, and Mussa. A restrictive feature of these models, however, is the small-country assumption that concentrates attention on the portfolio-adjustment behavior of domestic residents, who are assumed able to borrow or lend freely at a fixed foreign interest rate. A second limitation of these models is the lack of attention to credit risk, and in many cases to exchange risk as well. Needless to say, such abstractions don't square well with a world in which debt rescheduling has become commonplace and few countries can be found whose liabilities are either small or riskless from the perspective of their international creditors.
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