Sovereign Risk and the Effects of Fiscal Retrenchment in Deep Recessions

68 Pages Posted: 27 Sep 2011

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Andre Meier

International Monetary Fund (IMF)

Gernot J. Müller

University of Tuebingen - Department of Economics

Date Written: September 23, 2011

Abstract

The authors analyze the effects of government spending cuts on economic activity in an environment of severe fiscal strain, as reflected by a sizeable risk premium on government debt. Specifically, they consider a 'sovereign risk channel,' through which sovereign default risk spills over to the rest of the economy, raising funding costs in the private sector. The authors' analysis is based on a variant of the model suggested by Cúrdia and Woodford (2009). It allows for costly financial intermediation and inter-household borrowing and lending in equilibrium, but maintains the tractability of the baseline New Keynesian model. They show that, if monetary policy is constrained in offsetting the effect of higher sovereign risk on private-sector borrowing conditions, the sovereign risk channel exacerbates indeterminacy problems: private-sector beliefs of a weakening economy can become self-fulfilling. Under these conditions, fiscal retrenchment can limit the risk of macroeconomic instability. In addition, if fiscal strain is very severe and monetary policy is constrained for an extended period, fiscal retrenchment may actually stimulate economic activity.

Keywords: fiscal consolidation, monetary policy, zero lower bound, risk premium, sovereign risk channel

JEL Classification: E62, E52, E32

Suggested Citation

Corsetti, Giancarlo and Kuester, Keith and Meier, Andre and Müller, Gernot J., Sovereign Risk and the Effects of Fiscal Retrenchment in Deep Recessions (September 23, 2011). FRB of Philadelphia Working Paper No. 11-43, Available at SSRN: https://ssrn.com/abstract=1933804 or http://dx.doi.org/10.2139/ssrn.1933804

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
Italy
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Andre Meier

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Gernot J. Müller

University of Tuebingen - Department of Economics ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
126
Abstract Views
838
rank
273,649
PlumX Metrics