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Soverign risk and the effects of fiscal retrenchment in deep recessions

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Author Info

  • Giancarlo Corsetti
  • Keith Kuester
  • Andre Meier
  • Gernot J. Muller

Abstract

The authors analyze the effects of government spending cuts on economic activity in an environment of severe fiscal strain, as reflected by a sizeable risk premium on government debt. Specifically, they consider a "sovereign risk channel," through which sovereign default risk spills over to the rest of the economy, raising funding costs in the private sector. The authors' analysis is based on a variant of the model suggested by Cúrdia and Woodford (2009). It allows for costly financial intermediation and inter-household borrowing and lending in equilibrium, but maintains the tractability of the baseline New Keynesian model. They show that, if monetary policy is constrained in offsetting the effect of higher sovereign risk on private-sector borrowing conditions, the sovereign risk channel exacerbates indeterminacy problems: private-sector beliefs of a weakening economy can become self-fulfilling. Under these conditions, fiscal retrenchment can limit the risk of macroeconomic instability. In addition, if fiscal strain is very severe and monetary policy is constrained for an extended period, fiscal retrenchment may actually stimulate economic activity.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 11-43.

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Date of creation: 2011
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Handle: RePEc:fip:fedpwp:11-43

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Related research

Keywords: Fiscal policy ; Monetary policy;

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References

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  1. Troy Davig & Eric M. Leeper, 2005. "Generalizing the Taylor Principle," NBER Working Papers 11874, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Corsetti, Giancarlo & Müller, Gernot, 2012. "Multilateral economic cooperation and the international transmission of fiscal policy," CEPR Discussion Papers 8748, C.E.P.R. Discussion Papers.
  2. Albrecht Ritschl, 2012. "Reparations, deficits, and debt default: the Great Depression in Germany," Economic History Working Papers 44335, London School of Economics and Political Science, Department of Economic History.
  3. Tim Oliver Berg & Kai Carstensen & Hans-Werner Sinn, 2011. "Was kosten Eurobonds?," Ifo Schnelldienst, Ifo Institute for Economic Research at the University of Munich, vol. 64(17), pages 25-33, 09.

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