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Fiscal Discoveries and Yield Decouplings

Listed author(s):
  • Luis Catão
  • Ana Fostel
  • Romain Ranciere

The recent Eurozone debt crisis has witnessed sharp decouplings in cross-country bond yields without commensurate shifts in relative fundamentals. We rationalize this phenomenon in a model wherein countries with different fundamentals are on different equilibrium paths all along, but which become discernible only during bad times. Key ingredients are cross-country differences in the volatility and persistence of fiscal revenue shocks combined with their unobservability by investors. Differences in the cyclicality of fiscal revenues affect the option value of borrowing and resulting default risk; unobservability of fiscal shocks makes bond pricing responsive to market actions. When tax revenues are hit by common positive shocks, no country increases net debt and interest spreads stay put. When a common negative revenue shock hits and is persistent, low volatility countries adjust spending while others resort to borrowing. This difference signals a relative deterioration of fiscal outlooks, interest spreads jump and decoupling takes place.

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File URL: http://www.gwu.edu/~iiep/assets/docs/papers/2014WP/FostelIIEPWP201421.pdf
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Paper provided by The George Washington University, Institute for International Economic Policy in its series Working Papers with number 2014-21.

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Length: 56 pages
Date of creation: May 2014
Handle: RePEc:gwi:wpaper:2014-21
Contact details of provider: Web page: http://www.gwu.edu/~iiep/
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