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Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

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  • An earlier version of this article was published as IMF Working Paper 12/33. For very helpful comments, we thank Wouter den Haan (the editor), an anonymous referee, Santiago Acosta-Ormaechea, John Bluedorn, Fabian Bornhorst, Hafedh Bouakez, Antonio Fatas, Philip Lane, Thomas Laubach, Daniel Leigh, Ludger Schuknecht and the participants in seminars at the Board of Governors, Bundesbank-Banque de France, Goethe University, IMF, Midwest Macro Meetings, Society for Computational Economics and Sveriges Riksbank. Corsetti's work on this article is part of PEGGED, Contract no. SSH7-CT-2008-217559 within the 7th Framework Programme for Research and Technological Development. Support from the Pierre Werner Chair Programme at the EUI is gratefully acknowledged. This article was written while Kuester was affiliated with the Federal Reserve Bank of Philadelphia. The views expressed herein are those of the authors and do not necessarily represent those of the IMF, the Federal Reserve Bank of Philadelphia or the Federal Reserve System.

Corresponding author: Gernot Müller, University of Bonn, Adenauerallee 24-42, 53113 Bonn, Germany. E-mail: gernot.mueller@uni-bonn.de.

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.

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