Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

By Keith Kuester, Gernot J. Mueller, Giancarlo Corsetti, Andre Meier

January 1, 2012

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Keith Kuester, Gernot J. Mueller, Giancarlo Corsetti, and Andre Meier. Sovereign Risk, Fiscal Policy, and Macroeconomic Stability, (USA: International Monetary Fund, 2012) accessed December 22, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

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.

Subject: Expenditure, Financial services, National accounts, Public debt, Real interest rates, Return on investment, Zero lower bound

Keywords: Credit market, Debt level, Europe, Fiscal policy, Global, Government debt, Government spending, Monetary policy, Real interest rates, Retrenchment package, Return on investment, Risk premia, Risk premium, Sovereign risk, WP, Zero lower bound, ZLB episode

Publication Details

Pages:

56
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2012/033
Stock No:

WPIEA2012033
ISBN:

9781463933180
ISSN:

1018-5941

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