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Fiscal Deficits, Financial Fragility, and the Effectiveness of Government Policies

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  • Markus Kirchner

    (Central Bank of Chile)

  • Sweder van Wijnbergen

    (University of Amsterdam)

Abstract

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 banksinvest a substantial fraction of their assets in sovereign debt, the effectiveness of fiscal stimulus policies may be impaired because deficit-financed fiscal expansionsmay tighten financial conditions to such an extent that private demand is crowded out. We also analyze the macroeconomic effectiveness of liquidity supportto commercial banks through recapitalizations or loans by the government and the impact of different ways of financing those policies.

Suggested Citation

  • Markus Kirchner & Sweder van Wijnbergen, 2012. "Fiscal Deficits, Financial Fragility, and the Effectiveness of Government Policies," Tinbergen Institute Discussion Papers 12-044/2, Tinbergen Institute.
    • Handle: RePEc:tin:wpaper:20120044
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    More about this item

    Keywords

    Financial intermediation; Fiscal policy; Sovereign debt;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General

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