Estimating fiscal limits: the case of Greece

This paper uses Bayesian methods to estimate a real business cycle model that allows for interactions among fiscal policy instruments, the stochastic ‘fiscal limit’ and sovereign default. Using the particle filter to perform likelihood-based inference, we estimate the full nonlinear model with post-EMU data until 2010:Q4.We find that (i) the probability of default on Greek debt was in the range of 5–10% in 2010:Q4 and (ii) the 2011 surge in the Greek real interest rate is within model forecast bands. The results suggest that a nonlinear rational expectations environment can account for the Greek interest rate path.