Abstract
This paper examines the role of sovereign default beliefs for macroeconomic fluctuations and stabilization policy in a small open economy where fiscal solvency is a critical problem. We set up and estimate a DSGE model on Turkish data and show that accounting for sovereign risk significantly improves the fit of the model through an endogenous amplification between default beliefs, exchange rate and inflation movements. We then use the estimated model to study the implications of sovereign risk for stability, fiscal and monetary policy, and their interaction. We find that a relatively strong fiscal feedback from deficits to taxes, some exchange rate targeting or a monetary response to default premia are more effective and efficient stabilization tools than hawkish inflation targeting.
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Notes
Corsetti et al. (2014) show that a combination of sovereign risk in one region of a monetary union and procyclical fiscal policy at the aggregate level exacerbates the risk of belief-driven downturns.
See Hilscher and Nosbusch (2010).
Throughout, nominal (real) variables are denoted by capital (lower) letters, asterisks denote foreign variables and variables without time subscript (and bars) denote non-stochastic steady-state values.
The assumption that government purchases are fully allocated to domestically produced goods is motivated by empirical evidence for OECD countries of a strong home bias in government procurement, over and above that observed in private consumption.
These satisfy \(\Phi _{b}=\left( f_{{\bar{b}}}\left( b\right) -\frac{\partial F_{{\bar{b}} ,{\bar{d}}}\left( b,d\right) }{\partial {\bar{b}}}\right) b/\left( 1-\delta \right)\) and \(\Phi _{d}=\left( f_{{\bar{d}}}\left( d\right) -\frac{\partial F_{{\bar{b}},{\bar{d}}}\left( b,d\right) }{\partial {\bar{d}}}\right) d/\left( 1-\delta \right)\).
This assumption is made for technical reasons to prevent the discontinuity due to the resource transfer from foreign to domestic agents in the event of a default that would prohibit the use of local approximation methods.
In what follows, demanded and supplied quantities are denoted by the letters x and y, respectively.
Note that the trajectory of government debt has an impact on the private allocation when \(f>0\) through the effect of \(B_{F,t}\) through \(V_{t}\) on the private borrowing premium \(\Upsilon _{t}\). This is because (17) determines \(V_{t}\) while \(B_{F,t}\) is determined by \(X_{t}B_{F,t}/R_{F,t}=f_t B_{H,t}/R_{H,t}\) given total government debt which is determined by the government budget constraint (2). That is, Ricardian equivalence does not hold, independently of whether there is sovereign default risk or not. If \(\Upsilon _{t}\) depended instead on the sum of private and public foreign debt, then Ricardian equivalence would hold in the absence of sovereign risk.
We have verified that our main results are robust when estimating the model on data that was detrended using linear quadratic and Hodrick–Prescott filtered trends.
We calibrate the variances of the measurement errors to 5% of the sample variances of the corresponding data series. The measurement errors then mainly capture high-frequency movements in the data which the model cannot explain through the structural shocks.
We use gamma priors since under inverse gamma priors with fatter tails, the version of the model without sovereign risk relied upon a priori implausibly large shocks to match the data.
There is a fairly strong co-movement, although the EMBIG indicates smaller default premia before 2000 and during the mid-2000s (see appendix).
The better performance of \(M_1\) is corroborated when comparing the ability of both models to match selected moments especially of domestic consumption and investment. It comes closer to the data in terms of the standard deviations relative to output, correlations with output, as well as several standard deviations and autocorrelation coefficients. Moreover, the one-step ahead mean and mean squared forecast errors for most domestic variables is smaller in \(M_1\). These results are provided in appendix.
Krugman (2014) also discusses the role of monetary policy. He argues that a strong increase in the policy rate in the USA and the UK is unlikely as both monetary authorities are stuck at the effective lower bound (at the time of his writing). He allows, however, for the possibility that sovereign risk can be contractionary if the central banks aggressively raise rates in an attempt to maintain inflation and inflation expectations. This is what we find in our analysis. Whether higher sovereign risk is expansionary or contractionary also depends on structural characteristics and financial frictions, in particular, the size of the import share and the feedback from sovereign risk to private credit conditions (see Fig. 4).
Appendix contains the conditional variance decomposition at horizons of 1, 4, 12 and 40 quarters.
We use the persistence to distinguish these shocks empirically from i.i.d. domestic interest rate shocks.
On the other hand, the indeterminacy region, implied by a high fiscal response and a low monetary feedback (white area in lower right corner), is not affected by the presence of sovereign default beliefs.
Note that the sacrifice ratios in Fig. 9 are by far the highest for a cut in government consumption, while we learned from Fig. 7 in Sect. 4.5.2 that fiscal consolidation through a stronger tax feedback is most effective for reducing inflation volatility without sacrificing much in output volatility. This is due to two main forces. First, a feedback rule entails credible future commitment in response to all shocks hitting the economy, which is absent in a one-off cut in government spending. Second, as government consumption is biased toward domestic goods, a spending cut generates a relatively large fall in output and depreciation pressure which compensates the effect of the fiscal consolidation on the real exchange rate and inflation.
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Acknowledgements
The authors would like to thank Fabio Canova, Giancarlo Corsetti, Wouter den Haan, Javier García-Cicco, Markus Hörmann, Falko Juessen, Michael Krause, Alexander Kriwoluzky, Ludger Linnemann, Wolfram Richter, Andreas Schabert, Frank Schorfheide, Sweder van Wijnbergen, two anonymous referees and participants at various seminars and conferences for valuable comments. Funding: Rieth was partly financially supported by the Collaborative Research Center of the German Research Foundation (DFG) [grant SFB 823]. The views expressed in this paper do not necessarily reflect the position of the Central Bank of Chile or its Board members.
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