No. 859 - Optimal fiscal policy when agents fear government default

by Francesco Caprioli, Pietro Rizza and Pietro Tommasino
April 2012
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We derive the optimal fiscal policy for a government that is committed to honoring its debt but faces investors which fear a sovereign default. We assume that investors are able to learn from new evidence, as in Marcet and Sargent (1989), so that they can gradually correct their overly pessimistic view about the government's creditworthiness. We show that in an economy with these features, contrary to the prescriptions of standard models, a frontloaded fiscal consolidation after an adverse fiscal shock is optimal.

Published in 2011 in: Revue Economique, v. 62, 6, pp. 1031-1043

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  1. 23 April 2012
    No. 859 - Optimal fiscal policy when agents fear government default
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