Working Paper: CEPR ID: DP8779
Authors: Giancarlo Corsetti; Keith Kuester; Andr Meier; Gernot Müller
Abstract: 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.
Keywords: fiscal policy; monetary policy; risk premium; sovereign risk; zero lower bound
JEL Codes: E32; E52; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher public indebtedness (H69) | private-sector financing costs (G32) |
| private-sector financing costs (G32) | economic activity (E20) |
| higher public indebtedness (H69) | economic activity (E20) |
| sovereign risk (F34) | private credit conditions (G21) |
| sovereign risk (F34) | private-sector beliefs (P19) |
| private-sector beliefs (P19) | economic activity (E20) |
| fiscal retrenchment anticipation (E62) | determinacy in the economy (D59) |
| sovereign risk high and monetary policy constrained (E63) | spending multiplier (E62) |