We use the framework to bridge the response of consumption and output to fiscal shocks, thereby explicitly establishing the relevance of Ricardian considerations (i.e. private consumption effects) as a mechanism for a government’s fiscal position to matter for fiscal multipliers (i.e. output effects). Moreover, we use a much broader sample of countries and cover more recent data than Perotti (1999).

In theory, the interest rate channel operates through risk premia charged by risk averse investors. For example, Corsetti et al. (2013) employ a DSGE model in which sovereign risk premia rise (i.e. rising CDS spreads), in response to a deteriorating fiscal outlook of an economy (i.e. rising government debt) which then raises the economy’s overall borrowing costs. The closer to sovereign default, the greater the likelihood of tax increases and expenditure cuts that will erode firms’ profitability and households’ incomes. The resulting decline in private sector aggregate demand reduces the size of the multiplier. Given these theoretical insights, our main contribution is to provide an empirical assessment of the interest rate channel.<sup>13</sup> To show the relevance of the Ricardian and interest rate channels, we augment the baseline model with private consumption and CDS spreads. As discussed in Section 2, we order private consumption between government consumption and output, and CDS spreads last in the model. Including both variables allows us to assess the relevance of the two channels together in a “joint” model. However, the inclusion of CDS spreads significantly limits the sample: it removes observations before 2003 and those for 5 countries. To assess the relevance of the Ricardian channel, which can be studied using a larger sample, we also estimate the model with each channel separately. In fact, the model with only the Ricardian channel results in about twice the number of observations from the joint model that includes both channels. For these “separate” models, we retain the respective ordering of private consumption and CDS spreads as in the joint model.

We find statistically significant evidence that both channels operate in our sample. The upper two panels of Figure 3 show the impulse responses of private consumption and CDS spreads in response to a positive government consumption shock. Again, economies with weak fiscal positions are those with government debt in the 90<sup>th</sup> percentile in the sample; those with strong fiscal positions are economies with government debt in the 10<sup>th</sup> percentile. A fiscal stimulus in an economy with weak fiscal positions is associated with significantly lower private consumption for up to four years whereas a stimulus in an economy with strong fiscal positions significantly lifts private consumption for up to two years. The difference in the responses of private consumption is statistically significant, in the second and third year after the fiscal stimulus. A fiscal stimulus also raises CDS spreads significantly in an economy with weak fiscal positions for several years after the stimulus. In contrast, in economies with strong fiscal positions, CDS spreads typically do not respond statistically significantly to fiscal stimulus. Again, the difference between the responses of CDS spreads across two fiscal positions is statistically significant.

The lower two panels of Figure 3 illustrate fiscal multipliers, on impact and after two years, conditional on government debt. Impact fiscal multipliers range from about 0.2 for low government debt to virtually nil when government debt is high. Over time, after two years, these multipliers rise to 0.9 when government debt is low (in the 10<sup>th</sup> percentile) but about half as large (0.5) when debt is high (in the 90<sup>th</sup> percentile). Allowing for feedback loops with government consumption and CDS spreads has resulted in slightly larger fiscal multipliers when debt is low compared to the model that does not include them (Figure 1). This reflects the boost to private consumption that fiscal stimulus provides: when debt is low, there is limited need for precautionary household

> 13 There is a rich literature on the link between sovereign defaults and fiscal position, i.e. the level of debt (e.g. Arellano 2008; Mendoza and Yue 2012). Our paper studies how such linkages matter for the transmission of fiscal policy.

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