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.