Fiscal Austerity in Ambiguous Times
60 Pages Posted: 4 Apr 2016 Last revised: 29 Apr 2020
Date Written: 2016-03-01
This paper analyzes optimal fiscal policy with ambiguity aversion and endogenous government spending. We show that, without ambiguity, optimal surplus-to-output ratios are acyclical and that there is no rationale for either reduction or further accumulation of public debt. In contrast, ambiguity about the cycle can generate optimally policies that resemble "austerity" measures. Optimal policy prescribes higher taxes in adverse times and front-loaded fiscal consolidations that lead to a balanced primary budget in the long-run. This is the case when interest rates are sufficiently responsive to cyclical shocksâ€”that is, when the intertemporal elasticity of substitution is sufficiently low.
Keywords: public consumption, intertemporal elasticity of substitution, balanced budget, austerity, fiscal consolidation, ambiguity aversion, multiplier preferences
JEL Classification: D80, E62, H21, H63
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