Understanding sovereign risk and implications for fiscal policy and debt management

The euro area government debt crisis from 2010 onwards showed that even developed countries can be subject to massive doubts about fiscal sustainability, rapidly rising sovereign risk premia and even loss of market access for its debt. The extent of sovereign risk is related to a government’s ability to fund its expenditures and pay back its debt by raising tax and seigniorage income as well as market perceptions of its willingness to service its obligations in full. Available policy-focused macroeconomic models typically account for the dynamics of sovereign risk premia by incorporating serially correlated risk premium shocks. This work package aims to make progress in policy evaluation by modelling endogenous sovereign risk and resolve strategic and macroeconomic factors driving premia and fiscal sustainability. The modelling efforts benefit from the work accomplished under WP6.

Key Objectives

(O.10.1) Study the dynamics of sovereign debt and optimal monetary and fiscal policy when sovereign risk is endogenous and governments act strategically.

(O.10.2) Introduce endogenous sovereign default risks into DSGE models to be used for policy analysis and to study implications for the conduct of fiscal policy.

Main participants