Do Sovereign Yield Spreads Transmit Contractionary Fiscal Policy Shocks?

Abstract

• This chapter assesses the role of sovereign yield spreads in transmitting shocks to tax increases and government spending cut to GDP growth. First, we establish that sovereign spreads increase due to spending cuts and positive tax revenue shocks. The increase in spreads following the spending cuts and positive tax revenue shocks is consistent with contractionary fiscal policy shock effects. The results imply that the concurrence of the widening of yield spreads, fiscal consolidation and monetary policy tightening would reinforce each other in lowering GDP growth. Furthermore, evidence shows that an increase in yield spreads worsens the response of GDP growth to contractionary fiscal policy shocks.