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Cost of borrowing shocks and fiscal adjustment

  • Oliver de Groot
  • Fédéric Holm-Hadulla
  • Nadine Leiner-Killinger

Do capital markets impose fiscal discipline on governments? We investigate the responses of fiscal variables to a change in the interest rate paid by governments on their debt in a panel of 14 European countries over four decades. To this end, we estimate a panel vector autoregressive (PVAR) model, using sign restrictions via the penalty function method of Mountford and Uhlig (2009) to identify structural cost of borrowing shocks. Our baseline estimation shows that a 1 percentage point rise in the cost of borrowing leads to a cumulative improvement of the primary balance-to-GDP ratio of approximately 2 percentage points over 10 years, with the fiscal response becoming significantly evident only two years after the shock. We also find that the bulk of fiscal adjustment takes place via a rise in government revenue rather than a cut in primary expenditure. The size of the total fiscal adjustment, however, is insufficient to avoid the gross government debt-to-GDP ratio from rising as a consequence of the shock. Sub-dividing our sample, we also find that for countries participating in Economic and Monetary Union (EMU) the primary balance response to a cost of borrowing shock was stronger in the period after 1992 (the year in which the Maastricht Treaty was signed) than prior to 1992.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2013-59.

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Date of creation: 2013
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Handle: RePEc:fip:fedgfe:2013-59
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