Prudent Fiscal Policy in the Presence of Bailout Expectations
This paper analyzes the introduction of an automatic correction mechanism (ACM) in an economic union whose member states expect to be bailed out in the case of a debt crisis. An ACM can be used to penalize governments that run deficits. We show that if the mechanism is appropriately structured, it can harden the governmental budget constraints. Thus, in the presence of an ACM, bailout expectations of a regional government do not lead to excessive borrowing. However, we find that simultaneous introduction of an ACM and a credible commitment not to bail out indebted regions may lead to inefficiently hard budget constraints and an overshoot of the policy objectives.
Volume (Year): 68 (2012)
Issue (Month): 4 (December)
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