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Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

Sovereign Risk, Fiscal Policy, and Macroeconomic Stability by Keith Kuester
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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.
International Monetary Fund; January 2012
56 pages; ISBN 9781463977078
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Title: Sovereign Risk, Fiscal Policy, and Macroeconomic Stability
Author: Keith Kuester; Gernot J. Mueller; Giancarlo Corsetti; André Meier