Financial Fragility and the Fiscal Multiplier

Christiaan van der Kwaak, Sweder van Wijnbergen

Research output: Working paperAcademic

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Abstract

We show that undercapitalized banks with large holdings of government bonds subject to sovereign default risk lead to a new crowding-out channel: deficit-financed fiscal stimuli lead to higher bond yields, triggering capital losses for the banks. Banks then cut back loans, giving rise to potentially negative fiscal multipliers. Crowding out increases for longer maturity bonds and higher sovereign default risk. We estimate a DSGE model with financial frictions for Spain and find strong support for these results. The DSGE results further show strong nonlinear effects: the cumulative multiplier decreases substantially with the size of the stimulus, as well as with the amount of time between the announcement and implementation of the stimulus.
Original languageEnglish
Place of PublicationGroningein
PublisherUniversity of Groningen, FEB Research Institute
Number of pages145
Publication statusPublished - Nov-2023

Publication series

NameFEBRI Research Reports
PublisherUniversity of Groningen, FEB Research Institute
Volume2023006-EEF

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