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Fiscal transfers in a monetary union with sovereign risk

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  • Guilherme Bandeira

    () (Banco de España)

Abstract

This paper investigates the welfare and economic stabilization properties of a fiscal transfers scheme between members of a monetary union subject to sovereign spread shocks. The scheme, which consists of cross-country transfer rules triggered when sovereign spreads widen, is incorporated in a two-country model with financial frictions. In particular, banks hold government bonds in their portfolios, being exposed to sovereign risk. When this increases, a drop bank’s equity value forces them to contract credit and to raise lending rates at the same time as they retain funds to build up their net worth. I show that, when domestic fiscal policy is not distortionary, fiscal transfers improve welfare and macroeconomic stability. This is because fiscal transfers can reduce banks’ exposure to government debt, freeing credit supply to the private sector. On the contrary, when domestic fiscal policy is distortionary, fiscal transfers cause welfare losses, despite stabilizing the economy. This result arises because the distortions caused by funding the scheme outweigh the positive effects of fiscal transfers in smoothing the adjustment of the economy hit by the shock.

Suggested Citation

  • Guilherme Bandeira, 2018. "Fiscal transfers in a monetary union with sovereign risk," Working Papers 1807, Banco de España;Working Papers Homepage.
  • Handle: RePEc:bde:wpaper:1807
    as

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    File URL: https://www.bde.es/f/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosTrabajo/18/Files/dt1807e.pdf
    File Function: First version, February 2018
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    References listed on IDEAS

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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Fiscal transfers in a monetary union with sovereign risk
      by Christian Zimmermann in NEP-DGE blog on 2018-03-23 13:32:54

    More about this item

    Keywords

    sovereign risk; banks; monetary union; fiscal transfers;

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
    • F45 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Macroeconomic Issues of Monetary Unions

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