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Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy

Huixin Bi ()

Staff Working Papers from Bank of Canada

Abstract: We develop a closed economy model to study the interactions among sovereign risk premia, fiscal limits, and fiscal policy. The stochastic fiscal limits, which measure the ability and willingness of the government to service its debt, arise endogenously from a dynamic Laffer curve. The distribution of fiscal limits is country-specific, depending on the size of the government, the degree of countercyclical policy responses, economic diversity, and political uncertainty, among other characteristics. The model rationalizes different sovereign ratings across developed countries. A nonlinear relationship between sovereign risk premia and the level of government debt, which emerges in equilibrium, is consistent with the empirical evidence that once risk premia begin to rise, they do so rapidly. Movements in default risk premia for long-term bonds precede those for shortterm bonds, providing early warnings of increasing probabilities of sovereign defaults.

Keywords: Fiscal policy; International topics (search for similar items in EconPapers)
JEL-codes: E62 H30 H60 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2011
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mac
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Journal Article: Sovereign default risk premia, fiscal limits, and fiscal policy (2012) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:11-10

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