## Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

_IMF Working Papers, January 1, 2012_

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## Bibliographic details
- Authors: Keith Kuester, Gernot J. Mueller, Giancarlo Corsetti, Andre Meier
- Published: January 1, 2012
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781463933180.001

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### Summary and Key Findings
- 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.

### Mechanism: Sovereign Risk Channel
- 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.

### Implications for Fiscal and Monetary Policy
- 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.

### Policy Recommendations and Scenarios
- 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/sovereign-risk-fiscal-policy-and-macroeconomic-stability-25681_