spillovers in a monetary union with endogenous fiscal limits · spillovers in a monetary union with...

Spillovers in a Monetary Union with EndogenousFiscal Limits

Javier Andrés, Pablo Burriel and Wenyi Shen

Universidad de Valencia, Banco de España and Oklahoma State University

March 22, 2018

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 1 / 28

Motivation

General gov debt 10-year bond spreads

High gov. debt/GDP in EA raise concerns about debt sustainability.

What is the fiscal limit for a country in EMU?

What are the spillover effects on debt sustainability in EMU?

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 2 / 28

Motivation

General gov debt 10-year bond spreads

High gov. debt/GDP in EA raise concerns about debt sustainability.

What is the fiscal limit for a country in EMU?

What are the spillover effects on debt sustainability in EMU?

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 2 / 28

Motivation

General gov debt 10-year bond spreads

High gov. debt/GDP in EA raise concerns about debt sustainability.

What is the fiscal limit for a country in EMU?

What are the spillover effects on debt sustainability in EMU?

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 2 / 28

Structure of presentation

1 Introduction2 Preview of results3 Model4 Fiscal limit5 Long-run fiscal consolidation6 Short-run discretionary fiscal policy7 Conclusions

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 3 / 28

Aim of the paper

Build a two-country DSGE framework with endogenous sovereign risk premiafor countries in a monetary union, to show:- What are the determinants of fiscal limits?- How countries’fiscal limits interact in a monetary union?

Address central policy issues in highly-indebted economies.- Effects of fiscal consolidations- Effects of discretionary fiscal policy & coordination

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 4 / 28

Literature

Typical monetary union DSGE models assessing policy effects do notaccount for default risks: Gali & Monacelli (2008), Ferrero (2009).

Literature that assesses debt sustainability use structural framework withexogenous risk premia: Mendoza and Oviedo (2004), Corsetti et al. (2013).

Sovereign default literature internalizes some default cost but often assumesexogenous output: Aguiar and Gopinath (2006), Arellano et al. (2017).

Bi (2012), fiscal limits (FL) arise endogenously from dynamic Laffer curvesin a closed economy model.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 5 / 28

Literature

Typical monetary union DSGE models assessing policy effects do notaccount for default risks: Gali & Monacelli (2008), Ferrero (2009).

Literature that assesses debt sustainability use structural framework withexogenous risk premia: Mendoza and Oviedo (2004), Corsetti et al. (2013).

Sovereign default literature internalizes some default cost but often assumesexogenous output: Aguiar and Gopinath (2006), Arellano et al. (2017).

Bi (2012), fiscal limits (FL) arise endogenously from dynamic Laffer curvesin a closed economy model.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 5 / 28

Literature

Typical monetary union DSGE models assessing policy effects do notaccount for default risks: Gali & Monacelli (2008), Ferrero (2009).

Literature that assesses debt sustainability use structural framework withexogenous risk premia: Mendoza and Oviedo (2004), Corsetti et al. (2013).

Sovereign default literature internalizes some default cost but often assumesexogenous output: Aguiar and Gopinath (2006), Arellano et al. (2017).

Bi (2012), fiscal limits (FL) arise endogenously from dynamic Laffer curvesin a closed economy model.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 5 / 28

Literature

Typical monetary union DSGE models assessing policy effects do notaccount for default risks: Gali & Monacelli (2008), Ferrero (2009).

Literature that assesses debt sustainability use structural framework withexogenous risk premia: Mendoza and Oviedo (2004), Corsetti et al. (2013).

Sovereign default literature internalizes some default cost but often assumesexogenous output: Aguiar and Gopinath (2006), Arellano et al. (2017).

Bi (2012), fiscal limits (FL) arise endogenously from dynamic Laffer curvesin a closed economy model.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 5 / 28

Preview of results

Risk channel matters significally when debt is >90%.

- Makes long run consolidation to 60% costly, with spillovers to EA.- Reduces significantly multiplier of discretionary fiscal policy.- Endogenous risk premium explains 40% of that reduction.

Policy coordination favors joint consolidation, except under ZLB.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 6 / 28

Preview of results

Risk channel matters significally when debt is >90%.

- Makes long run consolidation to 60% costly, with spillovers to EA.- Reduces significantly multiplier of discretionary fiscal policy.- Endogenous risk premium explains 40% of that reduction.

Policy coordination favors joint consolidation, except under ZLB.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 6 / 28

Model highlights

Two-country New Keynesian model, modified only for:

Periphery with high debt & Core with low debt.

Periphery’s gov. debt is subject to default risk.

Total debt home bias.

(Distortionary taxes on income.)

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 7 / 28

Main mechanism:

The main novel mechanism comes from the interaction between:

1 Periphery’s High debt is subject to default risk.

2 Fiscal limit (FL) distribution is endogenous

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 8 / 28

Main mechanism:

The main novel mechanism comes from the interaction between:

1 Periphery’s High debt is subject to default risk.2 Fiscal limit (FL) distribution is endogenous

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 8 / 28

1) Risky Periphery’s government debt:

Periphery’s government debt (bt−1) is subject to default risk, withhaircut δ and risky yield Rt

δt =

{0 if bt−1 < B(St)δ if bt−1 ≥ B(St)

where B(St) is a random draw from fiscal limit distribution

Periphery household’s Euler eq includes risky yield & expected haircut:

λt = βEtRt(1− δt+1)λt+1

πt+1

Core gov debt is NOT risky: δ∗t = 0, R∗t = RECBt

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 9 / 28

1) Risky Periphery’s government debt:

Periphery’s government debt (bt−1) is subject to default risk, withhaircut δ and risky yield Rt

δt =

{0 if bt−1 < B(St)δ if bt−1 ≥ B(St)

where B(St) is a random draw from fiscal limit distribution

Periphery household’s Euler eq includes risky yield & expected haircut:

λt = βEtRt(1− δt+1)λt+1

πt+1

Core gov debt is NOT risky: δ∗t = 0, R∗t = RECBt

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 9 / 28

1) Risky Periphery’s government debt:

Periphery’s government debt (bt−1) is subject to default risk, withhaircut δ and risky yield Rt

δt =

{0 if bt−1 < B(St)δ if bt−1 ≥ B(St)

where B(St) is a random draw from fiscal limit distribution

Periphery household’s Euler eq includes risky yield & expected haircut:

λt = βEtRt(1− δt+1)λt+1

πt+1

Core gov debt is NOT risky: δ∗t = 0, R∗t = RECBt

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 9 / 28

2) Periphery’s Fiscal Limit:

B(St) = βpt π(St)Et

∞∑

j=0βj λ(St+j)

λ(St)

(T (St+j)−gt+j−z)

(TOT(St+j))1−η

where state of the economy St = {at, gt, a∗t , g∗t , TOTt−1}

Periphery’s Fiscal limit (B(St)) is the max debt that can besupported without default.

Iterate on the government budget constraint, assuming no default &tax rate set at max (τt=τmax)

τmax=peak of Laffer curve = 0.435 (Spain’s max marginal rate)

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 10 / 28

2) Periphery’s Fiscal Limit:

B(St) = βpt π(St)Et

∞∑

j=0βj λ(St+j)

λ(St)

(T (St+j)−gt+j−z)

(TOT(St+j))1−η

where state of the economy St = {at, gt, a∗t , g∗t , TOTt−1}

Periphery’s Fiscal limit (B(St)) is the max debt that can besupported without default.

Iterate on the government budget constraint, assuming no default &tax rate set at max (τt=τmax)

τmax=peak of Laffer curve = 0.435 (Spain’s max marginal rate)

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 10 / 28

2) Periphery’s Fiscal Limit:

B(St) = βpt π(St)Et

∞∑

j=0βj λ(St+j)

λ(St)

(T (St+j)−gt+j−z)

(TOT(St+j))1−η

where state of the economy St = {at, gt, a∗t , g∗t , TOTt−1}

Periphery’s Fiscal limit (B(St)) is the max debt that can besupported without default.

Iterate on the government budget constraint, assuming no default &tax rate set at max (τt=τmax)

τmax=peak of Laffer curve = 0.435 (Spain’s max marginal rate)

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 10 / 28

2) Periphery’s Fiscal Limit:

B(St) = βpt π(St)Et

∞∑

j=0βj 1

(TOT(St+j))1−η

λ(St+j)

λ(St)(T (St+j)− gt+j − z)

Endogenous: depends on the state of the economy.

Captures private sector’s perception of FL: HH’s discount factor.

βpt =stochastic political risk, AR1 [β

p < 1, εβp

t ∼ N[0, (σβp

)2]]→

generates plausible movements in risk premia.

FL distribution simulated using Markov Chain Monte Carlo method.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 11 / 28

2) Periphery’s Fiscal Limit:

B(St) = βpt π(St)Et

∞∑

j=0βj 1

(TOT(St+j))1−η

λ(St+j)

λ(St)(T (St+j)− gt+j − z)

Endogenous: depends on the state of the economy.

Captures private sector’s perception of FL: HH’s discount factor.

βpt =stochastic political risk, AR1 [β

p < 1, εβp

t ∼ N[0, (σβp

)2]]→

generates plausible movements in risk premia.

FL distribution simulated using Markov Chain Monte Carlo method.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 11 / 28

2) Periphery’s Fiscal Limit:

B(St) = βpt π(St)Et

∞∑

j=0βj 1

(TOT(St+j))1−η

λ(St+j)

λ(St)(T (St+j)− gt+j − z)

Endogenous: depends on the state of the economy.

Captures private sector’s perception of FL: HH’s discount factor.

βpt =stochastic political risk, AR1 [β

p < 1, εβp

t ∼ N[0, (σβp

)2]]→

generates plausible movements in risk premia.

FL distribution simulated using Markov Chain Monte Carlo method.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 11 / 28

2) Periphery’s Fiscal Limit:

B(St) = βpt π(St)Et

∞∑

j=0βj 1

(TOT(St+j))1−η

λ(St+j)

λ(St)(T (St+j)− gt+j − z)

Endogenous: depends on the state of the economy.

Captures private sector’s perception of FL: HH’s discount factor.

βpt =stochastic political risk, AR1 [β

p < 1, εβp

t ∼ N[0, (σβp

)2]]→

generates plausible movements in risk premia.

FL distribution simulated using Markov Chain Monte Carlo method.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 11 / 28

Periphery’s Fiscal Limit:

Distribution of Periphery’s FL computed from B (St)

Histogram Cumulative density function (cdf)

FL approx symmetric with mean=110%, sd=20

Prob of default = 0 for B/Y<60% & =1 for B/Y>180%

Between 60-180%: ⇑B/Y → ⇑default Prob

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 12 / 28

Periphery’s Fiscal Limit:

Distribution of Periphery’s FL computed from B (St)

Histogram Cumulative density function (cdf)

FL approx symmetric with mean=110%, sd=20

Prob of default = 0 for B/Y<60% & =1 for B/Y>180%

Between 60-180%: ⇑B/Y → ⇑default Prob

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 12 / 28

Periphery’s Fiscal Limit:

Distribution of Periphery’s FL computed from B (St)

Histogram Cumulative density function (cdf)

FL approx symmetric with mean=110%, sd=20

Prob of default = 0 for B/Y<60% & =1 for B/Y>180%

Between 60-180%: ⇑B/Y → ⇑default Prob

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 12 / 28

Periphery’s FL: Changes in g

⇑g → ⇑deficit, Y → ⇓FL

MP channel weak: small ⇑ YEA, πEA →small ⇑ RECB → ⇓FL⇒ Both negative → ⇓FL (shift left), ⇑ default prob (2% B/Y=125%)

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 13 / 28

Periphery’s FL: Changes in g

⇑g → ⇑deficit, Y → ⇓FLMP channel weak: small ⇑ YEA, πEA →small ⇑ RECB → ⇓FL⇒ Both negative → ⇓FL (shift left), ⇑ default prob (2% B/Y=125%)

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 13 / 28

Periphery’s FL: Spillover from g*

⇑g* → ⇑deficit*, Y∗, π∗

I MP channel: ⇑ RECB → ⇑ financing costs of debt → ⇓ FLI Trade channel: ⇑ M∗=X→ ⇑ FLI Net negative effect → ⇓FL, ⇑default prob (0.75% B/Y=125%)

Spillover is 40% of own effect (2% vs 0.75%).

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 14 / 28

Periphery’s FL: Spillover from g*

⇑g* → ⇑deficit*, Y∗, π∗

I MP channel: ⇑ RECB → ⇑ financing costs of debt → ⇓ FL

I Trade channel: ⇑ M∗=X→ ⇑ FLI Net negative effect → ⇓FL, ⇑default prob (0.75% B/Y=125%)

Spillover is 40% of own effect (2% vs 0.75%).

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 14 / 28

Periphery’s FL: Spillover from g*

⇑g* → ⇑deficit*, Y∗, π∗

I MP channel: ⇑ RECB → ⇑ financing costs of debt → ⇓ FLI Trade channel: ⇑ M∗=X→ ⇑ FL

I Net negative effect → ⇓FL, ⇑default prob (0.75% B/Y=125%)

Spillover is 40% of own effect (2% vs 0.75%).

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 14 / 28

Periphery’s FL: Spillover from g*

⇑g* → ⇑deficit*, Y∗, π∗

I MP channel: ⇑ RECB → ⇑ financing costs of debt → ⇓ FLI Trade channel: ⇑ M∗=X→ ⇑ FLI Net negative effect → ⇓FL, ⇑default prob (0.75% B/Y=125%)

Spillover is 40% of own effect (2% vs 0.75%).

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 14 / 28

Periphery’s FL: Spillover from g*

⇑g* → ⇑deficit*, Y∗, π∗

I MP channel: ⇑ RECB → ⇑ financing costs of debt → ⇓ FLI Trade channel: ⇑ M∗=X→ ⇑ FLI Net negative effect → ⇓FL, ⇑default prob (0.75% B/Y=125%)

Spillover is 40% of own effect (2% vs 0.75%).

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 14 / 28

Periphery’s FL under ZLB.

∆ Periphery’s g ∆ Core’s g*

debt/ss annual GDP0.5 1 1.5 2 2.5

%

­2

­1.5

­1

­0.5

0

0.5

1

1.5

2  d e f a u l t   p r o b a b i l i t y   r e l a t i v e   t o   t h e   s s

low ghigh glow g, at the ZLBhigh g, at the ZLB

debt/ss annual GDP0.5 1 1.5 2 2.5

%

­1

­0.5

0

0.5

1  d e f a u l t   p r o b a b i l i t y   r e l a t i v e   t o   t h e   s s

low ghigh glow g , at the ZLBhigh g , at the ZLB

No MP channel under ZLB =⇒ SMALLER effect of ∆g, g* on FL.

Smallest effect of ∆g* due to NO (strong) MP channel.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 15 / 28

Periphery’s FL under ZLB.

∆ Periphery’s g ∆ Core’s g*

debt/ss annual GDP0.5 1 1.5 2 2.5

%

­2

­1.5

­1

­0.5

0

0.5

1

1.5

2  d e f a u l t   p r o b a b i l i t y   r e l a t i v e   t o   t h e   s s

low ghigh glow g, at the ZLBhigh g, at the ZLB

debt/ss annual GDP0.5 1 1.5 2 2.5

%

­1

­0.5

0

0.5

1  d e f a u l t   p r o b a b i l i t y   r e l a t i v e   t o   t h e   s s

low ghigh glow g , at the ZLBhigh g , at the ZLB

No MP channel under ZLB =⇒ SMALLER effect of ∆g, g* on FL.Smallest effect of ∆g* due to NO (strong) MP channel.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 15 / 28

Policy scenario 1:

Peripherys’Long-run consolidation from B/Y=100 to 60%

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 16 / 28

Periphery’s Consolidation: B/Y 100-60%

0 20 400

50

100Risk premium (bps, diff)

0 20 400.3

0.35

0.4Tax rate (level)

0 20 400.5

1

1.5Debt/Y (level)

0 20 40­4

­2

0GDP

0 20 400

0.2

0.4Inflation

0 20 40

­4

­2

0Consumption

0 20 40

­4

­2

0Terms of trade

0 20 40­2

­1

0Foreign GDP

No default Endogenous FL

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

High debt requires significant ⇑ tax, ⇓ B/Y slowly, with high risk premium

Long and costly process (⇓Y, C & L), spillover to Core (⇓Y*).Lower cost with NO default.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 17 / 28

Periphery’s Consolidation: B/Y 100-60%

0 20 400

50

100Risk premium (bps, diff)

0 20 400.3

0.35

0.4Tax rate (level)

0 20 400.5

1

1.5Debt/Y (level)

0 20 40­4

­2

0GDP

0 20 400

0.2

0.4Inflation

0 20 40

­4

­2

0Consumption

0 20 40

­4

­2

0Terms of trade

0 20 40­2

­1

0Foreign GDP

No default Endogenous FL

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

High debt requires significant ⇑ tax, ⇓ B/Y slowly, with high risk premium

Long and costly process (⇓Y, C & L), spillover to Core (⇓Y*).

Lower cost with NO default.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 17 / 28

Periphery’s Consolidation: B/Y 100-60%

0 20 400

50

100Risk premium (bps, diff)

0 20 400.3

0.35

0.4Tax rate (level)

0 20 400.5

1

1.5Debt/Y (level)

0 20 40­4

­2

0GDP

0 20 400

0.2

0.4Inflation

0 20 40

­4

­2

0Consumption

0 20 40

­4

­2

0Terms of trade

0 20 40­2

­1

0Foreign GDP

No default Endogenous FL

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

High debt requires significant ⇑ tax, ⇓ B/Y slowly, with high risk premium

Long and costly process (⇓Y, C & L), spillover to Core (⇓Y*).Lower cost with NO default.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 17 / 28

Periphery’s Consolidation: Frontloaded?

0 20 400

50

100Risk premium (bps, diff)

Gradual Frontloaded

0 20 400.3

0.35

0.4Tax rate (level)

0 20 400.5

1

1.5Debt/Y (level)

0 20 40

­4

­2

0GDP

0 20 400

0.2

0.4Inflation

0 20 40

­4

­2

0Consumption

0 20 40­10

­5

0Terms of trade

0 20 40­4

­2

0Foreign GDP

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1Frontloaded ⇓ risk premium & long-run cost.

Initial greater ⇓Y due to flex wages: stronger ⇑tax→⇑W→⇑ RECB

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 18 / 28

Periphery’s Consolidation: Frontloaded?

0 20 400

50

100Risk premium (bps, diff)

Gradual Frontloaded

0 20 400.3

0.35

0.4Tax rate (level)

0 20 400.5

1

1.5Debt/Y (level)

0 20 40

­4

­2

0GDP

0 20 400

0.2

0.4Inflation

0 20 40

­4

­2

0Consumption

0 20 40­10

­5

0Terms of trade

0 20 40­4

­2

0Foreign GDP

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1Frontloaded ⇓ risk premium & long-run cost.

Initial greater ⇓Y due to flex wages: stronger ⇑tax→⇑W→⇑ RECB

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 18 / 28

Policy scenario 2:

Discretionary short-run fiscal policy (transitory ∆g, g∗)

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 19 / 28

Discretionary fiscal policy: 1% fall in g

0 20 40

­4

­2

0Risk premium (bps, diff)

0 20 40

­0.5

0Tax rate

0 20 40­2

­1

0Debt

0 20 40­0.2

0

0.2GDP

0 20 40­0.002

­0.001

0Real interest rate

0 20 400

0.1

0.2Terms of trade

0 20 400

0.02

0.04Foreign GDP

0 20 40­1

­0.5

0Gov spending

high debt (baseline)high debt, no defaulthigh debt, exogenous FL

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

With high debt, ⇓g→⇑FL, ⇓risk premium→ ⇑Y,C,TOT

Initial fall in Y, increase after 10q

MP channel weak: ⇓ πEA →small ⇓ RECB → ⇑ FL

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 20 / 28

Discretionary fiscal policy: 1% fall in g

0 20 40

­4

­2

0Risk premium (bps, diff)

0 20 40

­0.5

0Tax rate

0 20 40­2

­1

0Debt

0 20 40­0.2

0

0.2GDP

0 20 40­0.002

­0.001

0Real interest rate

0 20 400

0.1

0.2Terms of trade

0 20 400

0.02

0.04Foreign GDP

0 20 40­1

­0.5

0Gov spending

high debt (baseline)high debt, no defaulthigh debt, exogenous FL

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

With high debt, ⇓g→⇑FL, ⇓risk premium→ ⇑Y,C,TOTInitial fall in Y, increase after 10q

MP channel weak: ⇓ πEA →small ⇓ RECB → ⇑ FL

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 20 / 28

Discretionary fiscal policy: 1% fall in g

0 20 40

­4

­2

0Risk premium (bps, diff)

0 20 40

­0.5

0Tax rate

0 20 40­2

­1

0Debt

0 20 40­0.2

0

0.2GDP

0 20 40­0.002

­0.001

0Real interest rate

0 20 400

0.1

0.2Terms of trade

0 20 400

0.02

0.04Foreign GDP

0 20 40­1

­0.5

0Gov spending

high debt (baseline)high debt, no defaulthigh debt, exogenous FL

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

With high debt, ⇓g→⇑FL, ⇓risk premium→ ⇑Y,C,TOTInitial fall in Y, increase after 10q

MP channel weak: ⇓ πEA →small ⇓ RECB → ⇑ FL

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 20 / 28

Discretionary fiscal policy: 1% fall in g

0 20 40

­4

­2

0Risk premium (bps, diff)

0 20 40

­0.6

­0.4

­0.2

0Tax rate

0 20 40­2

­1

0Debt

0 20 40­0.2

0

0.2GDP

0 20 40­0.002

0

0.002Real interest rate

0 20 400

0.1

0.2Terms of trade

0 20 400

0.02

0.04Foreign GDP

0 20 40­1

­0.5

0Gov spending

low debt high debt

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

Relevance of Risk Premium channel with high debt

With high debt, ⇓g→⇑FL, ⇓default prob→ ⇑Y,C,TOT

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 21 / 28

Discretionary fiscal policy: 1% fall in g

0 20 40

­4

­2

0Risk premium (bps, diff)

0 20 40

­0.6

­0.4

­0.2

0Tax rate

0 20 40­2

­1

0Debt

0 20 40­0.2

0

0.2GDP

0 20 40­0.002

0

0.002Real interest rate

0 20 400

0.1

0.2Terms of trade

0 20 400

0.02

0.04Foreign GDP

0 20 40­1

­0.5

0Gov spending

low debt high debt

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

Relevance of Risk Premium channel with high debt

With high debt, ⇓g→⇑FL, ⇓default prob→ ⇑Y,C,TOT

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 21 / 28

Discretionary FP: 1% fall in g, ZLB

0 20 40

­4

­2

0Risk premium (bps, diff)

0 20 40

­0.5

0Tax rate

0 20 40­2

­1

0Debt

0 20 40­0.2

0

0.2GDP

0 20 40­0.005

0

0.005Real interest rate

0 20 400

0.1

0.2Terms of trade

0 20 40­0.05

0

0.05Foreign GDP

0 20 40­1

­0.5

0Gov spending

Unconstrained MP ZLB

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

Under ZLB the RP channel is muted:

Standard MP: ⇓g →⇓R & ⇓inf → constant RP → ⇑FL→⇓RP

ZLB: ⇓g →constant R, ⇓inf → ⇑ RP& ⇑FL→constant RP

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 22 / 28

Discretionary FP: 1% fall in g, ZLB

0 20 40

­4

­2

0Risk premium (bps, diff)

0 20 40

­0.5

0Tax rate

0 20 40­2

­1

0Debt

0 20 40­0.2

0

0.2GDP

0 20 40­0.005

0

0.005Real interest rate

0 20 400

0.1

0.2Terms of trade

0 20 40­0.05

0

0.05Foreign GDP

0 20 40­1

­0.5

0Gov spending

Unconstrained MP ZLB

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

Under ZLB the RP channel is muted:

Standard MP: ⇓g →⇓R & ⇓inf → constant RP → ⇑FL→⇓RP

ZLB: ⇓g →constant R, ⇓inf → ⇑ RP& ⇑FL→constant RP

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 22 / 28

Discretionary FP: Multipliers

Multiplier PV(DY)/PV(DG)models 0 1 yr 10 yr 0 1 yr 10 yr 0 1 yr 10 yrNo default 0.75 0.70 0.27 ­0.14 ­0.12 ­0.11 0.18 0.17 0.02Exogenous FL 0.75 0.70 ­0.20 ­0.14 ­0.12 ­0.19 0.18 0.17 ­0.20Endogenous FL 0.75 0.69 ­0.49 ­0.14 ­0.13 ­0.24 0.18 0.17 ­0.33

Endogenous FL, ZLB 0.80 0.75 0.45 ­0.09 ­0.07 0.01 0.23 0.22 0.17

Periphery Spillover to Core Euro area

Risk premium channel reduces long run multiplier by 76bp, of which29bp are due to endogenous FL

Spillover to EA reduces EA multiplier by 35bp, 13bp due to endo FL.

ZLB kills RP channel→ multiplier like in NO default case.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 23 / 28

Discretionary FP: Multipliers

Multiplier PV(DY)/PV(DG)models 0 1 yr 10 yr 0 1 yr 10 yr 0 1 yr 10 yrNo default 0.75 0.70 0.27 ­0.14 ­0.12 ­0.11 0.18 0.17 0.02Exogenous FL 0.75 0.70 ­0.20 ­0.14 ­0.12 ­0.19 0.18 0.17 ­0.20Endogenous FL 0.75 0.69 ­0.49 ­0.14 ­0.13 ­0.24 0.18 0.17 ­0.33

Endogenous FL, ZLB 0.80 0.75 0.45 ­0.09 ­0.07 0.01 0.23 0.22 0.17

Periphery Spillover to Core Euro area

Risk premium channel reduces long run multiplier by 76bp, of which29bp are due to endogenous FL

Spillover to EA reduces EA multiplier by 35bp, 13bp due to endo FL.

ZLB kills RP channel→ multiplier like in NO default case.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 23 / 28

Discretionary FP: Multipliers

Multiplier PV(DY)/PV(DG)models 0 1 yr 10 yr 0 1 yr 10 yr 0 1 yr 10 yrNo default 0.75 0.70 0.27 ­0.14 ­0.12 ­0.11 0.18 0.17 0.02Exogenous FL 0.75 0.70 ­0.20 ­0.14 ­0.12 ­0.19 0.18 0.17 ­0.20Endogenous FL 0.75 0.69 ­0.49 ­0.14 ­0.13 ­0.24 0.18 0.17 ­0.33

Endogenous FL, ZLB 0.80 0.75 0.45 ­0.09 ­0.07 0.01 0.23 0.22 0.17

Periphery Spillover to Core Euro area

Risk premium channel reduces long run multiplier by 76bp, of which29bp are due to endogenous FL

Spillover to EA reduces EA multiplier by 35bp, 13bp due to endo FL.

ZLB kills RP channel→ multiplier like in NO default case.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 23 / 28

Fiscal coordination: 1% rise in g*

0 20 400

0.5

1Risk premium (bps, diff)

0 20 40­0.2

­0.1

0

0.1Tax rate

0 20 40­0.5

0

0.5Debt

0 20 40­0.05

0

0.05GDP

0 20 40­0.005

0

0.005Real interest rate

0 20 400

0.02

0.04

0.06Terms of trade

0 20 40­0.1

0

0.1

0.2Foreign GDP

0 20 400

0.5

1Foreign gov spending

Unconstrained MP ZLB

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

⇑g* → ⇑deficit*, Y∗, π∗

I MP channel: ⇑ RECB > Trade channel → ⇓FL, ⇑RP → ⇓Y

Under ZLB, no MP channel → RP constant → ⇑Y.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 24 / 28

Fiscal coordination: 1% rise in g*

0 20 400

0.5

1Risk premium (bps, diff)

0 20 40­0.2

­0.1

0

0.1Tax rate

0 20 40­0.5

0

0.5Debt

0 20 40­0.05

0

0.05GDP

0 20 40­0.005

0

0.005Real interest rate

0 20 400

0.02

0.04

0.06Terms of trade

0 20 40­0.1

0

0.1

0.2Foreign GDP

0 20 400

0.5

1Foreign gov spending

Unconstrained MP ZLB

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

⇑g* → ⇑deficit*, Y∗, π∗

I MP channel: ⇑ RECB > Trade channel → ⇓FL, ⇑RP → ⇓Y

Under ZLB, no MP channel → RP constant → ⇑Y.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 24 / 28

Fiscal coordination: 1% rise in g*

0 20 400

0.5

1Risk premium (bps, diff)

0 20 40­0.2

­0.1

0

0.1Tax rate

0 20 40­0.5

0

0.5Debt

0 20 40­0.05

0

0.05GDP

0 20 40­0.005

0

0.005Real interest rate

0 20 400

0.02

0.04

0.06Terms of trade

0 20 40­0.1

0

0.1

0.2Foreign GDP

0 20 400

0.5

1Foreign gov spending

Unconstrained MP ZLB

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

0 0.5 10

0.5

1

⇑g* → ⇑deficit*, Y∗, π∗

I MP channel: ⇑ RECB > Trade channel → ⇓FL, ⇑RP → ⇓Y

Under ZLB, no MP channel → RP constant → ⇑Y.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 24 / 28

Conclusions:

Endogenous risk matters significally when debt is >90%.

Makes long run consolidation to 60% costly, with spillovers to EA.

Under high debt, risk premium channel reduces multiplier ofdiscretionary fiscal policy.considerably.

Endogenous risk premium explains 40% of that reduction.

Policy coordination favors joint consolidation, but ZLB mitigates thegains.

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 25 / 28

THANK YOU FOR YOUR ATTENTION

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 26 / 28

Standard Fiscal Policy:

Governments’Budget constraint:

Periphery :bt

Rt+ TOTη−1

t (T− gt − z) = (1− δt)bt−1

πt

Core :b∗t

RECBt

+ TOTη∗

t (T∗ − g∗t − z∗) =

b∗t−1

π∗t

Fiscal policy rules:

Periphery: τt = τ + γb(bt−1 − 0.6)Core: τ∗t = τ∗ + γb(b

∗t−1 − 0.6)

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 27 / 28

Standard Fiscal Policy:

Governments’Budget constraint:

Periphery :bt

Rt+ TOTη−1

t (T− gt − z) = (1− δt)bt−1

πt

Core :b∗t

RECBt

+ TOTη∗

t (T∗ − g∗t − z∗) =

b∗t−1

π∗t

Fiscal policy rules:

Periphery: τt = τ + γb(bt−1 − 0.6)Core: τ∗t = τ∗ + γb(b

∗t−1 − 0.6)

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 27 / 28

Calibration:

Periphery = Spain, Core = Germany

J.Andrés & P.Burriel (BdeE) Fiscal limits in EA March 22, 2018 28 / 28