DP8779 Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

Author(s): Giancarlo Corsetti, Keith Kuester, André Meier, Gernot Müller
Publication Date: January 2012
Keyword(s): fiscal policy, monetary policy, risk premium, sovereign risk, zero lower bound
JEL(s): E32, E52, E62
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8779

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.