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Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

  • Giancarlo Corsetti
  • Keith Kuester
  • André Meier
  • Gernot J. Müller

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.

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Article provided by Royal Economic Society in its journal The Economic Journal.

Volume (Year): (2013)
Issue (Month): (02)
Pages: F99-F132

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Handle: RePEc:ecj:econjl:v::y:2013:i::p:f99-f132
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  1. Ana M. Aizcorbe & Arthur B. Kennickell & Kevin B. Moore, 2003. "Recent changes in U.S. family finances: evidence from the 1998 and 2001 Survey of Consumer Finances," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 1-32.
  2. Troy Davig & Eric M. Leeper, 2005. "Generalizing the Taylor principle," Research Working Paper RWP 05-13, Federal Reserve Bank of Kansas City.
  3. Vincent Reinhart & Brian Sack, 2000. "The Economic Consequences of Disappearing Government Debt," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 31(2), pages 163-220.
  4. Ardagna, Silvia & Caselli, Francesco & Lane, Timothy, 2004. "Fiscal Discipline and the Cost of Public Debt Service: Some Estimates for OECD Countries," CEPR Discussion Papers 4661, C.E.P.R. Discussion Papers.
  5. Mertens, Karel & Ravn, Morten O, 2010. "Fiscal Policy in an Expectations Driven Liquidity Trap," CEPR Discussion Papers 7931, C.E.P.R. Discussion Papers.
  6. Ugo Panizza & Federico Sturzenegger & Jeromin Zettelmeyer, 2009. "The Economics and Law of Sovereign Debt and Default," Journal of Economic Literature, American Economic Association, vol. 47(3), pages 651-98, September.
  7. repec:dgr:uvatin:20110064 is not listed on IDEAS
  8. Vasco Cúrdia & Michael Woodford, 2009. "Credit frictions and optimal monetary policy," BIS Working Papers 278, Bank for International Settlements.
  9. Huixin Bi & Eric M. Leeper, 2010. "Sovereign Debt Risk Premia and Fiscal Policy in Sweden," NBER Working Papers 15810, National Bureau of Economic Research, Inc.
  10. Eduardo A. Cavallo & Patricio Valenzuela, 2007. "The Determinants of Corporate Risk in Emerging Markets; An Option-Adjusted Spread Analysis," IMF Working Papers 07/228, International Monetary Fund.
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