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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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File URL: http://www.bancaditalia.it/pubblicazioni/temi-discussione/2012/2012-0859/en_tema_859.pdf
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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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  24. Edda Zoli & Silvia Sgherri, 2009. "Euro Area Sovereign Risk During the Crisis," IMF Working Papers 09/222, International Monetary Fund.
  25. Eva Carceles-Poveda & Chryssi Giannitsarou, 2008. "Asset Pricing with Adaptive Learning," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(3), pages 629-651, July.
  26. Bayoumi, Tamim & Goldstein, Morris & Woglom, Geoffrey, 1995. "Do Credit Markets Discipline Sovereign Borrowers? Evidence from US States," CEPR Discussion Papers 1088, C.E.P.R. Discussion Papers.
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