Sovereign Risk, Fiscal Policy, and Macroeconomic Stability

This article analyses the impact of strained government finances on macroeconomic stability and the transmission of fiscal policy. Using a variant of the model by Cúrdia and Woodford (2009), we study a ‘sovereign risk channel’ through which sovereign default risk raises funding costs in the private sector. If monetary policy cannot offset increased credit spreads because it is constrained by the zero lower bound or otherwise, the sovereign risk channel exacerbates indeterminacy problems: private‐sector beliefs of a weakening economy may become self‐fulfilling. In addition, sovereign risk may amplify the effects of cyclical shocks. Under those conditions, fiscal retrenchment can help curtail the risk of macroeconomic instability and, in extreme cases, even bolster economic activity.