Cost of Borrowing Shocks and Fiscal Adjustment

37 Pages Posted: 14 Feb 2013

See all articles by Oliver de Groot

Oliver de Groot

University of Cambridge

Federic Holm-Hadulla

European Central Bank (ECB)

Nadine Leiner-Killinger

European Central Bank (ECB)

Multiple version iconThere are 2 versions of this paper

Date Written: December 27, 2012

Abstract

Do capital markets impose fiscal discipline on governments? We investigate the responses of fiscal variables to a change in the interest rate paid by governments on their debt in a panel of 14 European countries over four decades. This is done in the context of a panel vector autoregressive (PVAR) model, using sign restrictions via the penalty function method of Mountford and Uhlig (2009) to identify structural cost of borrowing shocks. Our baseline estimation shows that a one percentage point rise in the cost of borrowing leads to a cumulative improvement of the primary balance-to-GDP ratio of approximately 1.9 percentage points over 10 years, with the fiscal response becoming significantly evident only two years after the shock. We also find that the bulk of fiscal adjustment takes place via a rise in government revenue rather than a cut in primary expenditure. The size of the total fiscal adjustment, however, is insufficient to avoid the gross government debt-to-GDP ratio from rising as a consequence of the shock. Sub-dividing our sample, we also find that for countries participating in Economic and Monetary Union (EMU) the primary balance response to a cost of borrowing shock was stronger in the period after 1992 (the year in which the Maastricht Treaty was signed) than prior to 1992.

Keywords: Fiscal policy, long-term interest rates, vector-autoregressive models, sign restrictions

JEL Classification: C33, E43, E62, H60

Suggested Citation

de Groot, Oliver and Holm-Hadulla, Federic and Leiner-Killinger, Nadine, Cost of Borrowing Shocks and Fiscal Adjustment (December 27, 2012). ECB Working Paper No. 1503, Available at SSRN: https://ssrn.com/abstract=2194093

Oliver De Groot (Contact Author)

University of Cambridge ( email )

Trinity Ln
Cambridge, CB2 1TN
United Kingdom

Federic Holm-Hadulla

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Nadine Leiner-Killinger

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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