Abstract
This paper studies the dynamics of sovereign risk, fiscal policy and the macroeconomy in a two-country monetary union framework under the assumption of a heterogeneous perception of the determinants of sovereign risk by the government and the market participants. The macro-economic volatility resulting from various types of fiscal policy rules aimed at the stabilization of sovereign debt is investigated through numerical simulations. Among other things, these simulations show that an extreme focus on debt stabilization can be counterproductive if the financial markets care more about the country’s output gap.
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Notes
- 1.
In recent times, various studies have investigated the interaction between sovereign risk and economic activity in otherwise rather standard macroeconomic frameworks, see e.g. Adrian et al. (2010).
- 2.
The following exercise could be related in the EU case to the analysis of the interaction between Germany and Italy or Spain, for example.
- 3.
Given the behavioral approach of the present paper we do not include the expected future consumption as it is done in the standard Euler equations derived from intertemporal utility maximization under rational expectations.
- 4.
That is, in the words of Svensson (2003, p. 1), a rule which “expresses the central bank’s instrument (usually a short interest rate, the instrument rate […]) as an explicit function of information available to the central bank”.
- 5.
This quote, however, goes on as following: “Without prejudice of the objective of price stability the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community […].”
- 6.
Mayer and Stähler (2013, p. 13), using a DSGE framework, analyze also the performance of a balanced budget rule, finding that “due to erratic spending behavior, the balance budget rule tends to destabilize the economy and gives rise to sunspot equilibria. Cyclical fluctuations tend to be more pronounced under this regime and cyclical smoothing does not take place. In terms of welfare considerations, this regime also does comparatively poor.”
- 7.
We assume however that due to a home bias argument households hold primarily the bonds of the own government. Accordingly, and in order to clarify the main transmission channels of the model, we assume that only the yield on the respective government bonds enters into the private consumption equation (6).
- 8.
An early investigation referring to the driving forces of government bond yield spreads was carried out by Edwards (1984), who figured out that domestic fundamentals, such that public debt, inflation, etc. are important for the determination of the development of government spreads.
- 9.
Indeed, as previously mentioned, a stylized fact of the recent euro area debt crisis is the non-linear, apparently country-specific and state-dependent link between the sovereign risk premium and the underlying macroeconomic fundamentals of various euro area countries.
- 10.
Note that we abstract from aggregate investment in the current analysis, as thus from an endogenously determined potential output, given our focus on short-run effects.
- 11.
All numerical simulations in this paper were done using Dynare 4.3.3, see Adjemian et al. (2011). The codes are available from the author upon request.
- 12.
As previously mentioned, while Home could be related to Spain or Italy in the current euro area crisis, Foreign would represent Germany.
- 13.
Note that Proaño (2013) analyzed the impact of different fiscal policy rules under various sovereign risk perception configurations on aggregate volatility. He computed a loss function over several simulation runs which he employed as evaluation measure of aggregate volatility. He also highlighted the role of the trade balance as determinant of sovereign risk perceptions and its effect on the fluctuations of real economic activity in a monetary union.
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Acknowledgements
We gratefully acknowledge useful comments and suggestions by Willi Semmler, Lopamundra Banerjee, Lena Dräger, Philipp Engler, Sabine Stephan, Daniele Tavani, Ramaa Vasudevan and seminar participants at Colorado State University, the 2013 Eastern Economic Association conference, the 2012 FMM conference, the 2012 CFE conference, and the 2015 EEA conference, as well as Mary Borrowman for excellent research assistance. This is a significantly revised version of Proaño (2013). Financial support by the Macroeconomic Policy Institute (IMK) in the Hans-Böckler Foundation is gratefully acknowledged.
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Proaño, C.R., Lojak, B. (2017). Macroeconomic Risk, Fiscal Policy Rules and Aggregate Volatility in Asymmetric Currency Unions: A Behavioral Perspective. In: Bökemeier, B., Greiner, A. (eds) Inequality and Finance in Macrodynamics. Dynamic Modeling and Econometrics in Economics and Finance, vol 23. Springer, Cham. https://doi.org/10.1007/978-3-319-54690-2_10
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