Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

IMF Working Papers, January 1, 2012

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The 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), the authors 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.
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.

Sovereign default risk → raises funding costs in the private sector.
Higher private-sector funding costs → amplification of negative cyclical shocks.
Monetary policy constraints (e.g., zero lower bound) interact with sovereign risk to create indeterminacy where adverse beliefs can be self-fulfilling.

Monetary policy constraints increase vulnerability to sovereign risk–induced instability.
Fiscal retrenchment can be stabilizing when sovereign risk amplifies negative shocks and monetary policy is constrained; in extreme cases, retrenchment may stimulate activity.
The transmission of fiscal policy is altered by sovereign risk through higher private funding costs and changed expectations dynamics.

Consider fiscal retrenchment as a tool to reduce macroeconomic instability risk when sovereign default risk is significant and monetary policy is constrained.
Monitor interactions between sovereign risk premia, private-sector funding costs, and monetary policy space to assess the likelihood of indeterminate, belief-driven downturns.
Account for the possibility that sovereign risk amplifies cyclical downturns when designing fiscal and monetary responses.