Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

Abstract

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.

Fiscal consolidation and its cross-country effects

“…In other words, we assume that the domestic country does not take any active …scal consolidation measures but it just stabilizes the public debt-to-GDP ratio at its average level, where the latter, namely the public debt target in the country's feedback policy rules, is de…ned to be the steady state value of the public debt-to-GDP ratio as determined residually by the withinperiod government budget constraint. That is, in this country, we depart from, and end up at, the same tax-spending position, which is as in the average data in Germany (however, as To understand this scenario, imagine that the economy is hit by a temporary adverse shock to TFP as modelled in equations (23)- (24). This, as the impulse response functions can…”

“…24 Since Q= < Q = in the data over the period under consideration, it follows = 0:9833 > = 0:9780. That is, the Germans are more patient than the Italians.…”

“…As Corsetti et al (2013) point out, there are two approaches to sovereign default. The …rst approach models it as a strategic choice of the government (see e.g.…”

Sovereign Stress, Banking Stress, and the Monetary Transmission Mechanism in the Euro Area

“…And Brutti and Sauré (2015) show that cross-country bank exposures to sovereign debt of Euro area countries propagate sovereign risk. Focusing on sovereign risk alone, Corsetti et al (2013) argue that the costs of financial intermediation depend on sovereign risk and that higher government risk premiums therefore also increase the wedge between the risk-free rate and private borrowing costs. Besides unconventional monetary policy measures, also other aspect influence sovereign risk premiums.…”

“…8 See Corsetti et al (2013) and Zoli (2013) for further considerations on the effects of non-performing loans. on sovereign bonds which as described above are an explicit target of the ECB's unconventional monetary policy actions.…”