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Fiscal deficits, financial fragility, and the effectiveness of government policies

  • Kirchner, Markus
  • van Wijnbergen, Sweder

Recent macro developments in the euro area have highlighted the interactions between fiscal policy, sovereign debt, and financial fragility. We take a structural macroeconomic model with frictions in the financial intermediation process, in line with recent research, but introduce asset choice and sovereign debt holdings in the portfolio of banks. Using this model, we emphasize a new crowding-out mechanism that works through reduced private access to credit when banks accumulate sovereign debt under a leverage constraint. Our results show that, when banks invest a substantial fraction of their assets in sovereign debt, the effectiveness of fiscal stimulus policies may be impaired because deficit-financed fiscal expansions may tighten financial conditions to such an extent that private demand is crowded out. We also analyze the macroeconomic effectiveness of liquidity support to commercial banks through recapitalizations or loans by the government and the impact of different ways of financing those policies.

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Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Papers with number 20/2012.

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Date of creation: 2012
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Handle: RePEc:zbw:bubdps:202012
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  1. Michael Kumhof & Dirk Muir & Carlos de Resende & Jan in ‘t Veld & René Lalonde & Davide Furceri & Annabelle Mourougane & John Roberts & Stephen Snudden & Mathias Trabandt & Günter Coenen & Susanna, 2010. "Effects of Fiscal Stimulus in Structural Models," IMF Working Papers 10/73, International Monetary Fund.
  2. Thorsten Drautzburg & Harald Uhlig, 2011. "Fiscal Stimulus and Distortionary Taxation," 2011 Meeting Papers 481, Society for Economic Dynamics.
  3. Lawrence Christiano & Daisuke Ikeda, 2011. "Government Policy, Credit Markets and Economic Activity," NBER Working Papers 17142, National Bureau of Economic Research, Inc.
  4. Gertler, Mark & Kiyotaki, Nobuhiro & Queralto, Albert, 2012. "Financial crises, bank risk exposure and government financial policy," Journal of Monetary Economics, Elsevier, vol. 59(S), pages S17-S34.
  5. F. Gerard Adams & Byron Gangnes, 2010. "Why Hasn’t the US Economic Stimulus Been More Effective? The Debate on Tax and Expenditure Multipliers," Working Papers 201010, University of Hawaii at Manoa, Department of Economics.
  6. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  7. Erzo G. J. Luttmer, 1999. "What Level of Fixed Costs Can Reconcile Consumption and Stock Returns?," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 969-997, October.
  8. Christoffel, Kai & Coenen, Günter & Warne, Anders, 2008. "The New Area-Wide Model of the euro area: a micro-founded open-economy model for forecasting and policy analysis," Working Paper Series 0944, European Central Bank.
  9. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
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