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Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy

  • Huixin Bi

    ()

    (Indiana University - Bloomington)

We develop a closed economy model in order to study the interactions among sovereign risk premia, fiscal limits and fiscal policy. The stochastic fiscal limit, which measures the ability and willingness of the government to service its debt, arises endogenously from dynamic Laffer Curves. The distribution of fiscal limits is countryspecific, depending on the size of the government, the degree of the counter-cyclical policy responses, economic diversity and political uncertainty, and, therefore, the model can rationalize different sovereign ratings across developed countries. The model also produces a nonlinear relationship between sovereign risk premia and the level of government debt. The nonlinearity is consistent with the empirical evidence that once risk premia begin to rise, they do so rapidly. The default risk premia of long-term bonds jump ahead of short-term bonds and provide early warnings of sovereign defaults.

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File URL: http://www.iub.edu/~caepr/RePEc/PDF/2010/CAEPR2010-007.pdf
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Paper provided by Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington in its series Caepr Working Papers with number 2010-007.

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Length: 29 pages
Date of creation: May 2010
Date of revision:
Handle: RePEc:inu:caeprp:2010-007
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