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Discussion Paper Details

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Title: Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

Author(s): Giancarlo Corsetti, Keith Kuester, André Meier and Gernot Müller

Publication Date: January 2012

Keyword(s): fiscal policy, monetary policy, risk premium, sovereign risk and zero lower bound

Programme Area(s): International Macroeconomics

Abstract: 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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Bibliographic Reference

Corsetti, G, Kuester, K, Meier, A and Müller, G. 2012. 'Sovereign Risk, Fiscal Policy, and Macroeconomic Stability'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=8779