Fiscal Sustainability and Policy Interactions

Francesco Bianchi, Giovanni Callegari, Ermal Hitaj and Konstantinos Theodoridis
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Ermal Hitaj: European Stability Mechanism

No E2024/13, Cardiff Economics Working Papers from Cardiff University, Cardiff Business School, Economics Section

Abstract: We build a model to study the interaction between default risk, policy changes, and financial frictions within a monetary union. The model features a centralised central bank and decentralised fiscal authorities. Countries have different reputations for fiscal stability, modelled as different probabilities of moving to a Default regime. Borrowing costs for the fiscal authority and firms are affected by the possibility of default. This creates a feedback effect between debt accumulation, reputation, and the depth of a recession following adverse shocks. In this context, we discuss the benefits and limitations of a coordinated monetary and fiscal policy response that removes the risk of default. Adverse energy shocks generate more benign outcomes if accommodated, while a fiscal crisis leads to a vicious circle of debt accumulation, recession, and inflationary pressure. In this case, default and inflation risks and reinforce each other.

Keywords: Euro Area; default; fiscal policy; inflation; large public debt; financial frictions (search for similar items in EconPapers)
JEL-codes: E30 E50 E62 (search for similar items in EconPapers)
Pages: 57 pages
Date: 2024-06
New Economics Papers: this item is included in nep-bec and nep-mac
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