Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

56 Pages Posted: 2 Feb 2012

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

Multiple version iconThere are 2 versions of this paper

Date Written: January 2012

Abstract

This paper analyzes the impact of strained government finances on macroeconomic stability and the transmission of fiscal policy. Using a variant of the model by Curdia and Woodford (2009), we study a "sovereign risk channel" through which sovereign default risk raises funding costs in the private sector. If monetary policy is constrained, the sovereign risk channel exacerbates indeterminacy problems: private-sector beliefs of a weakening economy may become self-fulfilling. In addition, sovereign risk amplifies the effects of negative cyclical shocks. Under those conditions, fiscal retrenchment can help curtail the risk of macroeconomic instability and, in extreme cases, even stimulate economic activity.

Keywords: Zero Lower Bound, Risk Premium, Sovereign Risk, Sovereign Debt

JEL Classification: E32, E52, E62

Suggested Citation

Corsetti, Giancarlo and Kuester, Keith and Meier, Andre and Müller, Gernot J., Sovereign Risk, Fiscal Policy, and Macroeconomic Stability (January 2012). IMF Working Paper No. NO.12/33, Available at SSRN: https://ssrn.com/abstract=1997746

Giancarlo Corsetti

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

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