Fiscal multipliers within the euro area in the context of sovereign risk and bank fragility

Abstract

This work quantifies the size of fiscal multipliers in an economy with sovereign and bank default risks. The paper presents an estimated two-region dynamic stochastic general equilibrium model with financial frictions for the euro area, where the interplay of corporate, bank, and sovereign solvency risk affects the transmission of government spending. Sovereign bonds carry a credit risk premium that is particularly sensitive to government indebtedness in some regions of the currency union. The banking system is fragile due to its direct and indirect exposure to sovereign risk and limited loss absorption capacity. By calibrating the model on sovereign and bank riskiness reminiscent of the euro area Sovereign Debt Crisis, we show that adverse financial channels may significantly depress the transmission of expansionary government spending shocks. The modeling approach also enables assessing the scope for monetary and regulatory policies to mitigate financial setbacks and restore the effectiveness of fiscal interventions.