Fiscal Multipliers with Sovereign Risk and Fragile Banks

We quantify the size of fiscal multipliers in an economy with sovereign and bank default risk. We build a DSGE model with financial frictions for the euro area in which the interplay of corporate, bank and sovereign solvency risk a?ects the transmission of government spending. Sovereign bonds carry a credit risk premium that depends on government indebtedness. The banking system is fragile through its direct and indirect exposure to sovereign risk and limited loss absorption capacity. Calibrating the model on sovereign and bank riskiness reminiscent of the euro area sovereign debt crisis period, we show that adverse financial channels may signifcantly depress the fiscal multiplier. The trade-o? for the fiscal authority, between the macroeconomic stabilization objective and solvency risks, continues to be relevant in the euro area. We also evaluate the scope for monetary and macro-prudential policy to mitigate the financial setbacks and help restore the e?ectiveness of fiscal stimulus.