Government Spending Effects In A Policy Constrained Environment PDF Download

"We analyze the effects of government spending cuts on economic activity in an environment of severe fiscal strain, as reflected by a sizeable risk premium on government debt. Specifically, we consider a "sovereign risk channel," through which sovereign default risk spills over to the rest of the economy, raising funding costs in the private sector. Our analysis is based on a variant of the model suggested by C'urdia and Woodford (2009). It allows for costly financial intermediation and inter-household borrowing and lending in equilibrium, but maintains the tractability of the baseline New Keynesian model. We show that, if monetary policy is constrained in offsetting the effect of higher sovereign risk on private-sector borrowing conditions, the sovereign risk channel exacerbates indeterminacy problems: private-sector beliefs of a weakening economy can become self-fulfilling. Under these conditions, fiscal retrenchment can limit the risk of macroeconomic instability. In addition, if fiscal strain is very severe and monetary policy is constrained for an extended period, fiscal retrenchment may actually stimulate economic activity.