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

Caprioli, Francesco and Rizza, Pietro and Tommasino, Pietro, Optimal Fiscal Policy When Agents Fear Government Default (March 16, 2012). Bank of Italy Temi di Discussione (Working Paper) No. 859. Available at SSRN: https://ssrn.com/abstract=2045534 or http://dx.doi.org/10.2139/ssrn.2045534

Francesco Caprioli (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

Pietro Rizza

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Pietro Tommasino

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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