This article analyses the impact of strained government finances on macroeconomic stability and the transmission of fiscal policy. Using a variant of the model by Cúrdia and Woodford (2009), we study a ‘sovereign risk channel’ through which sovereign default risk raises funding costs in the private sector. If monetary policy cannot offset increased credit spreads because it is constrained by the zero lower bound or otherwise, the sovereign risk channel exacerbates indeterminacy problems: private‐sector beliefs of a weakening economy may become self‐fulfilling. In addition, sovereign risk may amplify the effects of cyclical shocks. Under those conditions, fiscal retrenchment can help curtail the risk of macroeconomic instability and, in extreme cases, even bolster economic activity.

This paper studies how the effects of government spending vary with the economic environment. Using a panel of OECD countries, we identify fiscal shocks as residuals from an estimated spending rule and trace their macroeconomic impact under different conditions regarding the exchange rate regime, public indebtedness, and health of the financial system. The unconditional responses to a positive spending shock broadly confirm earlier findings. However, conditional responses differ systematically across exchange rate regimes, as real appreciation and external deficits occur mainly under currency pegs. We also find output and consumption multipliers to be unusually high during times of financial crisis.

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may AbstractThe impact of fiscal stimulus depends not only on short-term tax and spending policies, but also on expectations about offsetting measures in the future. This paper analyzes the effects of an increase in government spending under a plausible debt-stabilizing policy that systematically reduces spending below trend over time, in response to rising public liabilities. Accounting for such spending reversals brings an otherwise standard new Keynesian model in line with the stylized facts of fiscal transmission, including the crowding-in of consumption and the 'puzzle' of real exchange rate depreciation. Time series evidence for the U.S. supports the empirical relevance of endogenous spending reversals.