Financial Fragility and the Fiscal Multiplier

Christiaan van der Kwaak and Sweder van Wijnbergen
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Sweder van Wijnbergen: University of Groningen

No 2023006-EEF, Research Report from University of Groningen, FEB Research Institute (FEBRI)

Abstract: We show that undercapitalized banks with large holdings of government bonds subject to sovereign default risk lead to a new crowding-out channel: deficit-financed fiscal stimuli lead to higher bond yields, triggering capital losses for the banks. Banks then cut back loans, giving rise to potentially negative fiscal multipliers. Crowding out increases for longer maturity bonds and higher sovereign default risk. We estimate a DSGE model with financial frictions for Spain and find strong support for these results. The DSGE results further show strong nonlinear effects: the cumulative multiplier decreases substantially with the size of the stimulus, as well as with the amount of time between the announcement and implementation of the stimulus.

Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:gro:rugfeb:2023006-eef

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