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Fiscal transfers in a monetary union with sovereign risk

Guilherme Bandeira ()
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Guilherme Bandeira: Banco de España

No 1807, Working Papers from Banco de España, Working Papers Homepage

Abstract: This paper investigates the welfare and economic stabilization properties of a fiscal transfers scheme between members of a monetary union subject to sovereign spread shocks. The scheme, which consists of cross-country transfer rules triggered when sovereign spreads widen, is incorporated in a two-country model with financial frictions. In particular, banks hold government bonds in their portfolios, being exposed to sovereign risk. When this increases, a drop bank’s equity value forces them to contract credit and to raise lending rates at the same time as they retain funds to build up their net worth. I show that, when domestic fiscal policy is not distortionary, fiscal transfers improve welfare and macroeconomic stability. This is because fiscal transfers can reduce banks’ exposure to government debt, freeing credit supply to the private sector. On the contrary, when domestic fiscal policy is distortionary, fiscal transfers cause welfare losses, despite stabilizing the economy. This result arises because the distortions caused by funding the scheme outweigh the positive effects of fiscal transfers in smoothing the adjustment of the economy hit by the shock.

Keywords: sovereign risk; banks; monetary union; fiscal transfers (search for similar items in EconPapers)
JEL-codes: E62 F41 F42 F45 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge and nep-mac
Date: 2018-02
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