Sovereign Risk, Fiscal Policy, and Macroeconomic Stability
January 1, 2012
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Summary
This paper analyzes the impact of strained government finances on macroeconomic stability and the transmission of fiscal policy. Using a variant of the model by Curdia and Woodford (2009), we study a "sovereign risk channel" through which sovereign default risk raises funding costs in the private sector. If monetary policy is constrained, the sovereign risk channel exacerbates indeterminacy problems: private-sector beliefs of a weakening economy may become self-fulfilling. In addition, sovereign risk amplifies the effects of negative cyclical shocks. Under those conditions, fiscal retrenchment can help curtail the risk of macroeconomic instability and, in extreme cases, even stimulate economic activity.
Subject: Expenditure, Financial services, National accounts, Public debt, Real interest rates, Return on investment, Zero lower bound
Keywords: credit market, debt level, Europe, Fiscal policy, Global, government debt, government spending, monetary policy, Real interest rates, retrenchment package, Return on investment, risk premia, risk premium, sovereign risk, WP, zero lower bound, ZLB episode
Pages:
56
Volume:
2012
DOI:
Issue:
033
Series:
Working Paper No. 2012/033
Stock No:
WPIEA2012033
ISBN:
9781463933180
ISSN:
1018-5941
