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Optimal fiscal policy when agents fear government default

Listed author(s):
  • Francesco Caprioli

    ()

    (Bank of Italy)

  • Pietro Rizza

    ()

    (Bank of Italy)

  • Pietro Tommasino

    ()

    (Bank of Italy)

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.

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Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 859.

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Date of creation: Mar 2012
Handle: RePEc:bdi:wptemi:td_859_12
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  12. Bayoumi, Tamim & Goldstein, Morris & Woglom, Geoffrey, 1995. "Do Credit Markets Discipline Sovereign Borrowers? Evidence from the U.S. States," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1046-1059, November.
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  25. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
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