Fiscal and Monetary Policy Coordination, Macroeconomic Stability, and Sovereign Risk Premia

• Published date: 01 March 2019
• Author: DENNIS BONAM,JASPER LUKKEZEN
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/jmcb.12577

DOI: 10.1111/jmcb.12577

DENNIS BONAM

JASPER LUKKEZEN

Fiscal and Monetary Policy Coordination,

Macroeconomic Stability, and Sovereign

Risk Premia

In standard macroeconomic models, equilibrium stability and uniqueness re-

quire monetary policy to actively target inflation and fiscal policy to ensure

long-run debt sustainability. We show analytically that these requirements

change, and depend on the cyclicality of fiscal policy, when government

debt is risky. In that case, budget deficits raise interest rates and crowd out

consumption. Consequently, countercyclical fiscal policies reduce the pa-

rameter space supporting stable and unique equilibria and are feasible only if

complemented with more aggressive debt consolidation and/or active mon-

etary policy. Stability is more easily achieved, however, under procyclical

fiscal policies.

JEL codes: E52, E62, E63

Keywords: fiscal-monetary policy interactions, equilibrium stability and

uniqueness, sovereign risk premia, countercyclical and procyclical fiscal

policy.

DURING THE GREAT RECESSION,GOVERNMENTS worldwide

engaged in massive fiscal expansions to keep their economies afloat, especially

since monetary instruments have been effectively depleted. In some cases, these

We would like to thank Giancarlo Corsetti, Peter van Els, Bart Hobijn, David Hollanders, ´

Ide

Kearney, Christiaan van der Kwaak, Christian Stoltenberg, and seminar participants at the Nederlandse

Economendag 2013, Utrecht University,CPB, RGS, IWH/INFER, and University of Cambridge for com-

ments. All errors are our own. The views expressed do not necessarily reflect the official position of De

Nederlandsche Bank or the Eurosystem.

DENNIS BONAM is at Econometrics and Modelling Department, De Nederlandsche Bank (E-mail:

d.a.r.bonam@dnb.nl). JASPER LUKKEZEN is at Law, Economics and Governance Department, Utrecht

University and at Economisch Statistische Berichten, FD Mediagroep(E-mail: lukkezen@economie.nl).

Received November 12, 2015; and accepted in revised form April 9, 2018.

Journal of Money, Credit and Banking, Vol.51, Nos. 2–3 (March–April 2019)

C

2018 The Authors. Journal of Money, Credit and Banking published by Wiley Periodicals,

Inc. on behalf of Ohio State University

This is an open access article under the terms of the Creative Commons Attribution-NonCom-

mercial License, which permits use, distribution and reproduction in any medium, provided

the original work is properly cited and is not used for commercial purposes.

582 :MONEY,CREDIT AND BANKING

Keynesian-style fiscal policies have resulted in a surge of government indebtedness

and widening sovereign bond yields, mostly reflecting concerns regarding the

sustainability of public finances. In more critical cases, the fiscal response to the

crisis did more harm than good, as the risk of sovereign default became too high and

eventually led to a collapse of sovereign bond markets. This begs the question: how

do the requirements for a sustainable path for sovereign debt affect the use of fiscal

policy in stabilizing macroeconomic conditions?

We address this question through the lens of the canonical New Keynesian closed

economy model in which a fiscal authority (or “government”) follows a feedback

rule that relates the primary balance to changes in government debt and aggregate

output, and a monetary authority (or “central bank”) that follows a standard Taylor

rule (Taylor 1993). Leeper (1991) has already shown that a stable equilibrium exists

when the response of the primary balance to an increase in debt is sufficient to

maintain debt growth below the long-run real interest rate, and that uniqueness is

ensured when this “passive fiscal policy” is paired with an “active monetary policy,”

which ensures that the nominal interest rate moves by more than one-for-one with

inflation.1We depart from the canonical model in one important way. To capture

the recently observed changes in the demand elasticity for government bonds, we

introduce a sovereign risk premium which forms a wedge between the bond rate and

risk-free rate. The risk premium rises with expected sovereign default, which itself is

a function of government indebtedness, and remains constant otherwise.

When the sovereign risk premium depends on the levelof debt, the well-established

stability and uniqueness requirements from Leeper (1991) change markedly and

depend strongly on the government’s endogenous fiscal response to the business

cycle. Showing this result analytically and numerically is our main contribution.

In particular, we find that, in the presence of sovereign risk, a stable and unique

equilibrium might be unattainable when the government maintains a countercyclical

fiscal stance, even if fiscal policy is passive and monetary policy active. This is due

to a crowding-out effect of sovereign risk on consumption that is exacerbated under

a countercyclical fiscal stance. Intuitively, when a shock adversely hits the economy

and the primary surplus falls, the stock of government debt rises. This drives up the

sovereign risk premium and the interest rate. Consequently, agents save more and

consume less, causing output and inflation to fall. Given the countercyclical nature of

fiscal policy,the government then automatically raises the deficit further, which again

drives up debt and the risk premium, causing consumption and output to fall even

more, and so on. By signaling its commitment to debt sustainability and pursuing

a more aggressive debt consolidation policy, the government is able to avoid this

self-reinforcing cycle of rising debt and falling output, and keep long-term financing

costs low. The required debt consolidation efforts rise with the responsiveness of the

sovereign risk premium to government indebtedness.

1. According to the Fiscal Theory of the Price Level, stability and uniqueness can also be ensured

when fiscal policy is insufficient to deliver long-run debt sustainability, only if the central bank allows

the price level to keep the real value of government debt outstanding consistent with the intertemporal

government budget constraint (see Leeper 1991, Sims 1994, Woodford1998, 2001, among others).

DENNIS BONAM AND JASPERLUKKEZEN :583

The required “passiveness,” or debt consolidation effort, of fiscal policyt hatdeliv-

ers equilibrium stability depends, not only on the severity of the sovereign debt crisis,

but also on monetary policy. If monetary policy is active, the rise in the sovereign

risk premium and consequent fall in inflation is met by a reduction in the policy

rate, which partially offsets the crowding-out effect. However, the less responsive

is the central bank to changes in inflation, for instance when the zero lower bound

is binding, the weaker is this monetary offset. Keeping the risk premium low then

requires greater debt reduction by the government. In Leeper (1991), only limited

coordination between fiscal and monetary policy is necessary: given a passive fiscal

stance, it is not the “activeness” of monetary policy that matters for stability, only

that monetary policy is indeed active. However, with a debt-elastic sovereign risk

premium, we find that the interdependence between fiscal and monetary policy is

much stronger and closer coordination between the government and central bank is

warranted.

When the governmentmaintains a procyclical fiscal stance, the stability and unique-

ness requirements under a debt-elastic sovereign risk premium are relaxed. Particu-

larly, when output contractions are followed by an increase in the primary surplus,

government debt falls following an adverse shock to output. In that case, the risk

premium and interest rate fall, and consumption rises, which offsets the initial output

contraction. The procyclical nature of fiscal policy thus not only eases the task of

sustaining government debt by keeping the risk premium low, which makes it possi-

ble to obtain stability even if fiscal policy is not passive, it also helps control inflation

by essentially substituting for monetary policy, which opens up the possibility for

determinacy even if monetary policy is not active.

A corollary of our results is that short-run deficits matter when the risk premium is

sensitive to the levelof government debt. When the debt-elasticity of the risk premium

is large, the government must take immediate action and signal its commitment to

control debt dynamics. If it does not, then the onus of ensuring stable macroeconomic

conditions falls entirely upon the central bank. Our results therefore formalize the

need for greater measures of fiscal austerity during times of sovereign debt crises and

also questions the desirability of fiscal expansions when public finances are critically

weak.

The present paper is closely related to the literature on the relationship between

macroeconomic stability and government debt nonneutrality.For instance, Canzoneri

and Diba (2005) and Linnemann and Schabert (2010) show that the conditions for

equilibrium stability change when government bonds can be used for transactions.

In these studies, an increase in the amount of government bonds outstanding has a

positive, rather than negative,effect on output and inflation through a reduction in the

liquidity premium. Fiscal policy is therefore able to accommodate monetary policy

in controlling inflation, and determinacy can be achieved evenwhen monetary policy

is not active. Piergallini (2005) and Leith and von Thadden (2008) show that similar

results can be derived in overlapping generations models in which governmentbonds

generate wealth effects. Furthermore, Schabert and vanWijnbergen (2014) investigate

the implications of debt nonneutrality arising from sovereign default risk using an