Working Paper: CEPR ID: DP10485
Authors: Tryphon Kollintzas; Konstantinos Tsoukalas
Abstract: We develop a dynamic stochastic general equilibrium model to study bank risk and sovereign risk interdependence in the Euro Area. We find that an increase in capital investment risk shock, results in a considerably deeper recession when sovereign risk is also present. This result has three policy implications. First, Euro Area policies dealing with failing banks aggravated the recession. Second, although there has been a supranational effort with the creation of the EFSF/ESM to provide loans to sovereigns, as long as there is no direct mechanism for financial sector rescues, Euro Area policies continue to exacerbate the recession. Third, in favor of austerity measures used in the EA, we find that government spending multipliers are smaller in the presence of sovereign risk.
Keywords: bank rescues; cyclicality; DSGE model; government spending multiplier; investment risk; sovereign risk
JEL Codes: E32; E44; E52; E58; E62; E63; G21; H3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in capital investment risk shock (E22) | deeper recession (E32) |
| deeper recession (E32) | higher external finance premium (G19) |
| higher external finance premium (G19) | influences government debt levels (H63) |
| influences government debt levels (H63) | raises probability of sovereign default (F34) |
| raises probability of sovereign default (F34) | economic decline (F44) |