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Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

Author/Editor: Keith Kuester | Gernot J. Mueller | Giancarlo Corsetti | André Meier
Authorized for Distribution: January 1, 2012
Electronic Access: Free Full Text (PDF file size is 1,469KB)
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

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.
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Series: Working Paper No. 12/33
Subject(s): Risk premium | Sovereign debt
Author's keyword(s): Fiscal policy | monetary policy | zero lower bound | risk premium | sovereign risk
    Published:   January 1, 2012        
    ISBN/ISSN:   9781463933180/1018-5941   Format:   Paper
    Stock No:   WPIEA2012033   Pages:   56
    Price:   US$18.00
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