Financial Fragility and the Fiscal Multiplier
Tinbergen Institute Discussion Paper 14-004/VI/DSF70
99 Pages Posted: 7 Jan 2014 Last revised: 26 Oct 2017
Date Written: September 19, 2017
We investigate the effectiveness of fiscal stimuli when banks are undercapitalized and have large holdings of government bonds subject to sovereign default risk. Deficit-financed government purchases then crowd out private expenditure and fiscal multipliers can turn negative. Crowding out increases for longer maturity bonds and higher sovereign default risk. We estimate a DSGE model with financial frictions for Spain and find that investment crowding out indeed leads to a negative cumulative fiscal multiplier. When monetary policy is exogenous, like at the ZLB or in a currency union, fiscal stimuli become more effective but multipliers are reduced when banks are undercapitalized.
Keywords: Financial Intermediation, Macrofinancial Fragility, Fiscal Policy, Sovereign Default Risk
JEL Classification: E44, E62, H30
Suggested Citation: Suggested Citation