Fiscal Deficits, Financial Fragility, and the Effectiveness of Government Policies

64 Pages Posted: 21 Jun 2016

See all articles by Markus Kirchner

Markus Kirchner

Central Bank of Chile

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: 2012

Abstract

Recent macro developments in the euro area have highlighted the interactions between fiscal policy, sovereign debt, and financial fragility. We take a structural macroeconomic model with frictions in the financial intermediation process, in line with recent research, but introduce asset choice and sovereign debt holdings in the portfolio of banks. Using this model, we emphasize a new crowding-out mechanism that works through reduced private access to credit when banks accumulate sovereign debt under a leverage constraint. Our results show that, when banks invest a substantial fraction of their assets in sovereign debt, the effectiveness of fiscal stimulus policies may be impaired because deficit-financed fiscal expansions may tighten financial conditions to such an extent that private demand is crowded out. We also analyze the macroeconomic effectiveness of liquidity support to commercial banks through recapitalizations or loans by the government and the impact of different ways of financing those policies.

Keywords: financial intermediation, fiscal policy, sovereign debt

JEL Classification: E44, E62, H30

Suggested Citation

Kirchner, Markus and van Wijnbergen, Sweder, Fiscal Deficits, Financial Fragility, and the Effectiveness of Government Policies (2012). Bundesbank Discussion Paper No. 20/2012. Available at SSRN: https://ssrn.com/abstract=2796880

Markus Kirchner (Contact Author)

Central Bank of Chile ( email )

United States

Sweder Van Wijnbergen

Universiteit van Amsterdam ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands
+31 20 525 4011 / 4203 (Phone)
+31-35-624 91 82 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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