Discussion paper

DP8779 Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

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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Citation

Corsetti, G, G Müller, K Kuester and A Meier (2012), ‘DP8779 Sovereign Risk, Fiscal Policy, and Macroeconomic Stability‘, CEPR Discussion Paper No. 8779. CEPR Press, Paris & London. https://cepr.org/publications/dp8779