Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy

Center for Applied Economics and Policy Research Working Paper No. 007-2010

29 Pages Posted: 27 May 2010  

Huixin Bi

Indiana University Bloomington

Multiple version iconThere are 2 versions of this paper

Date Written: May 24, 2010

Abstract

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 country specific, 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.

JEL Classification: E62, H30, H60

Suggested Citation

Bi, Huixin, Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy (May 24, 2010). Center for Applied Economics and Policy Research Working Paper No. 007-2010. Available at SSRN: https://ssrn.com/abstract=1616801 or http://dx.doi.org/10.2139/ssrn.1616801

Huixin Bi (Contact Author)

Indiana University Bloomington ( email )

100 South Indiana Ave.
Bloomington, IN 47405
United States

HOME PAGE: http://mypage.iu.edu/~hbi/

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