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Debt sustainability and fiscal space in a heterogeneous Monetary Union: normal times vs the zero lower bound

Author

Listed:
  • Javier Andrés

    (Universidad de Valencia)

  • Pablo Burriel

    (Banco de España)

  • Wenyi Shen

    (Oklahoma State University)

Abstract
In this paper we study fiscal policy effects and fiscal space for countries in a monetary union with different levels of public debt. We develop a dynamic stochastic general equilibrium (DSGE) model of a two-country monetary union, calibrated to match the characteristics of Spain and Germany, in which debt sustainability is endogenously determined a la Bi (2012) to shape the responses of the risk premium on public debt. Policy shocks change the market’s expectation about future primary surplus, producing a direct effect on the sovereign risk premium and macroeconomic responses of the economy. In normal times the costs of a government spending driven fiscal consolidation in the high-debt country are greatly diminished when this consolidation improves endogenously its debt sustainability prospects. Fiscal consolidations in both members of the monetary union decrease real interest rates and amplify the reduction in risk premium in the highly-indebted country, improving union-wide output in the long run, but at the cost of lower output in the low-debt country in the short term. On the contrary, when monetary policy is constrained at the zero lower bound, the risk premium channel arising from the endogenous determination of debt sustainability becomes muted. In the ZLB, a fiscal consolidation generates deflation expectations which increase the real interest rate and may compensate partially or completely, depending on the calibration, the benefits from a lower risk premium. In this context, a fiscal expansion in the low-debt country and a consolidation in the high-debt country delivers the greater positive impact on union-wide output. Finally, the risk premium channel only affects countries with medium or low levels of public debt indirectly through the negative spillovers from other high-debt members of the monetary union.

Suggested Citation

  • Javier Andrés & Pablo Burriel & Wenyi Shen, 2020. "Debt sustainability and fiscal space in a heterogeneous Monetary Union: normal times vs the zero lower bound," Working Papers 2001, Banco de España.
    • Handle: RePEc:bde:wpaper:2001
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    Cited by:

    1. Hürtgen, Patrick, 2020. "Fiscal sustainability duringthe COVID-19 pandemic," Discussion Papers 35/2020, Deutsche Bundesbank.
    2. Mario Alloza & Javier Andrés & Pablo Burriel & Iván Kataryniuk & Javier J. Pérez & Juan Luis Vega, 2021. "La reforma del marco de gobernanza de la política fiscal de la Unión Europea en un nuevo entorno macroeconómico," Occasional Papers 2121, Banco de España.
    3. Debrun, Xavier & Masuch, Klaus & Ferrero, Guiseppe & Vansteenkiste, Isabel & Ferdinandusse, Marien & von Thadden, Leopold & Hauptmeier, Sebastian & Alloza, Mario & Derouen, Chloé & Bańkowski, Krzyszto, 2021. "Monetary-fiscal policy interactions in the euro area," Occasional Paper Series 273, European Central Bank.
    4. Mario Alloza & Javier Andrés & Pablo Burriel & Iván Kataryniuk & Javier J. Pérez & Juan Luis Vega, 2021. "The reform of the european Union’s fiscal governance Framework in a new Macroeconomic environment," Occasional Papers 2121, Banco de España.

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    More about this item

    Keywords

    fiscal sustainability; sovereign debt default risk; monetary union;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General

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