Essays on international finance: sovereign default, fiscal policy and financial intermediation

Abstract

This research proposal aims at deepening the study of fiscal policy and debt crises in an economy facing frictions in financial intermediation. The purpose is to understand how fiscal policy affects default risk and the health of the financial sector, taking into account the following trade-off: a fiscal contraction in order to serve maturing debt might be costly in terms of output and welfare in the short run but, on the other hand, a debt restructuring is potentially harmful for banks and financial intermediation for the productive sector. In order to have a better sense of which effect dominates, the question calls for a quantitative analysis in a model that incorporates important short-run mechanisms such as nominal rigidities, firm-level frictions and monetary and fiscal policy interaction. Besides, there is an important political economy issue involved in the problem, since governments might face internal political resistance to raise resources, even though they might be willing to repay debt. To proceed with this analysis we intend to build upon an off-the-shelf macro-model in which banks hold risky sovereign debt and extend it to incorporate the above mentioned short run frictions and political economy constraints. Although many authors study debt crises and financial intermediation, little has been done in the direction of integrating both for policy debate, as the economic downturn of last European crisis has made explicit. Our contribution is hence to fill in this gap and give some elements to the discussion about the merits of fiscal austerity during debt crises, specially in the presence of financial frictions. (AU)