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This paper analyzes the impact of strained government finances on macroeconomic stability and the transmission of fiscal policy. Using a variant of the model by Curdia and Woodford (2009), we study a "sovereign risk channel" through which sovereign default risk raises funding costs in the private sector. If monetary policy is constrained, the sovereign risk channel exacerbates indeterminacy problems: private-sector beliefs of a weakening economy may become self-fulfilling. In addition, sovereign risk amplifies the effects of negative cyclical shocks. Under those conditions, fiscal retrenchment can help curtail the risk of macroeconomic instability and, in extreme cases, even stimulate economic activity.

Country risk --- Economic stabilization --- Fiscal policy --- Monetary policy --- Tax policy --- Taxation --- Economic policy --- Finance, Public --- Adjustment, Economic --- Business stabilization --- Economic adjustment --- Stabilization, Economic --- Country risk, Political --- Political risk (Foreign investments) --- Risk --- Econometric models. --- Government policy --- Banks and Banking --- Investments: General --- Public Finance --- Business Fluctuations --- Cycles --- Monetary Policy --- Fiscal Policy --- Interest Rates: Determination, Term Structure, and Effects --- Investment --- Capital --- Intangible Capital --- Capacity --- National Government Expenditures and Related Policies: General --- Debt --- Debt Management --- Sovereign Debt --- Public finance & taxation --- Finance --- Macroeconomics --- Zero lower bound --- Return on investment --- Expenditure --- Public debt --- Real interest rates --- Financial services --- National accounts --- Interest rates --- Saving and investment --- Expenditures, Public --- Debts, Public --- United States