Cost of Borrowing Shocks and Fiscal Adjustment

34 Pages Posted: 4 Nov 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: July 30, 2013

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. To this end, we estimate 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 1 percentage point rise in the cost of borrowing leads to a cumulative improvement of the primary balance-to-GDP ratio of approximately 2 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, VARs, 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 (July 30, 2013). FEDS Working Paper No. 2013-59, Available at SSRN: https://ssrn.com/abstract=2348176 or http://dx.doi.org/10.2139/ssrn.2348176

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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