Fiscal and Monetary Policy Coordination, Macroeconomic Stability, and Sovereign Risk Premia

Abstract

In standard macroeconomic models, equilibrium stability and uniqueness require monetary policy to actively target inflation and fiscal policy to ensure long-run debt sustainability. We show analytically that these requirements change, and depend on the cyclicality of fiscal policy, when government debt is risky. In that case, budget deficits raise interest rates and crowd out consumption. Consequently, countercyclical fiscal policies reduce the parameter space supporting stable and unique equilibria and are feasible only if complemented with more aggressive debt consolidation and/or active monetary policy. Stability is more easily achieved, however, under procyclical fiscal policies.