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Sovereign default risk premia, fiscal limits, and fiscal policy

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  • Bi, Huixin

Abstract

We develop a closed economy model to study the interactions among sovereign risk premia, fiscal limits, and fiscal policy. The fiscal limits, which measure the government's ability to service its debt, arise endogenously from dynamic Laffer curves. The state-dependent distributions of fiscal limits depend on the growth of lump-sum transfers, the size of the government, the degree of countercyclical policy responses, and economic diversity. The country-specific fiscal limits imply that the market perceives the riskiness of sovereign debt issued by different countries to be different, which is consistent with the observation that developed countries are downgraded at different levels of debt. A nonlinear relationship between sovereign risk premia and the level of government debt emerges in equilibrium, which is in line with the empirical evidence that once risk premia begin to rise, they do so rapidly. Nonlinear simulations show that fiscal austerity measures that aim to balance the government budget in the short run fail to contain the default risk premium, even with sizeable cuts in government purchases; but a long-term plan for fiscal reform, if it credibly changes the market's expectation about future fiscal policies, can alleviate the rising risk premium.

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Bibliographic Info

Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 56 (2012)
Issue (Month): 3 ()
Pages: 389-410

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Handle: RePEc:eee:eecrev:v:56:y:2012:i:3:p:389-410

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Keywords: Sovereign default risk premia; Fiscal limit; Laffer curve;

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  1. Arteta, Carlos & Hale, Galina, 2008. "Sovereign debt crises and credit to the private sector," Journal of International Economics, Elsevier, vol. 74(1), pages 53-69, January.
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  10. Daniel, Betty C. & Shiamptanis, Christos, 2012. "Fiscal risk in a monetary union," European Economic Review, Elsevier, vol. 56(6), pages 1289-1309.
  11. Wilbur John Coleman II, 1989. "Equilibrium in a production economy with an income tax," International Finance Discussion Papers 366, Board of Governors of the Federal Reserve System (U.S.).
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Citations

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Cited by:
  1. Betty C. Daniel & Christos Shiamptanis, 2010. "Sovereign Default Risk in a Monetary Union," Working Papers 2010-3, Central Bank of Cyprus.
  2. Betty Daniel & Christos Shiamptanis, 2012. "Pushing the Limit? Fiscal Policy in the European Monetary Union," Working Papers 033, Ryerson University, Department of Economics.
  3. R. Anton Braun & Tomoyuki Nakajima, 2011. "Making the case for a low intertemporal elasticity of substitution," Working Paper 2011-13, Federal Reserve Bank of Atlanta.
  4. Christos Shiamptanis, 2012. "Risk Assessment Under a Non-linear Fiscal Rule," Working Papers 038, Ryerson University, Department of Economics.
  5. Adriana Soares Sales & João Barata Ribeiro Blanco Barroso, 2012. "Coping with a Complex Global Environment: a Brazilian perspective on emerging market issues," Working Papers Series 292, Central Bank of Brazil, Research Department.
  6. R. Anton Braun & Tomoyuki Nakajima, 2011. "Why Prices Don't Respond Sooner to a Prospective Sovereign Debt Crisis," KIER Working Papers 796, Kyoto University, Institute of Economic Research.

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