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Optimal fiscal policy when agents fear government default

Author

Listed:
  • Francesco Caprioli

    (Bank of Italy)

  • Pietro Rizza

    (Bank of Italy)

  • Pietro Tommasino

    (Bank of Italy)

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.

Suggested Citation

  • Francesco Caprioli & Pietro Rizza & Pietro Tommasino, 2012. "Optimal fiscal policy when agents fear government default," Temi di discussione (Economic working papers) 859, Bank of Italy, Economic Research and International Relations Area.
    • Handle: RePEc:bdi:wptemi:td_859_12
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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

    Citations

    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. What to do when people expect the government to default on its debt
      by Economic Logician in Economic Logic on 2012-05-16 19:13:00

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    More about this item

    Keywords

    Ramsey-optimal fiscal policy; non-contingent public debt; learning.;
    All these keywords.

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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