Abstract: Diverse fiscal policies, which are subject to fiscal limits and stochastic shocks, can threaten price stability in a monetary union. The fiscal limits arise due to distortionary taxation and political will. Stochastic shocks are random and could push a fiscally sound policy towards its limit. In equilibrium agents refuse to lend along a path which violates the fiscal limits, creating a crisis. The crisis requires a policy response to restore lending. We focus on two responses, default and policy switching, both of which must be designed to restore fiscal solvency. Under the assumption that agents know the policy response, we show that default poses no risk to price stability, but that policy switching does. We simulate the model to quantify fiscal risk in the European Monetary Union with fiscal variables at end of 2009 values. We find that the probability of a fiscal crisis in Greece and Italy, countries whose debt relative to GDP had strayed far above the 60 percent limit, is positive but small. However, a small increase in debt can lead to a large increase in risk.
Publication Year: 2012
Publication Date: 2012-08-01
Language: en
Type: article
Indexed In: ['crossref']
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Cited By Count: 33
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