Optimal Fiscal Policy When Agents Fear Government Default
36 Pages Posted: 26 Apr 2012
Date Written: March 16, 2012
Abstract
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.
Keywords: Ramsey-optimal fiscal policy, non-contingent public debt, learning
JEL Classification: D83, E62
Suggested Citation: Suggested Citation
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