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Self-fulfilling debt crises, fiscal policy and investment

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  • Galli, Carlo

Abstract

This paper studies the circular relationship between sovereign credit risk, government fiscal and debt policy, and output. I consider a sovereign default model with fiscal policy and private capital accumulation. I show that, when fiscal policy responds to borrowing conditions in the sovereign debt market, multiple equilibria exist where the expectations of lenders are self-fulfilling. In the bad equilibrium, pessimistic beliefs make sovereign debt costly. The government substitutes borrowing with taxation, which depresses private investment and future output, increases default probabilities and verifies lenders’ beliefs. This result is reminiscent of the European debt crisis of 2010-12: while recessionary, fiscal austerity may be the government best response to excessive borrowing costs during a confidence crisis.

Suggested Citation

  • Galli, Carlo, 2019. "Self-fulfilling debt crises, fiscal policy and investment," LSE Research Online Documents on Economics 100942, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:100942
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    More about this item

    Keywords

    Self-fulfilling debt crises; sovereign default; multiple equilibria; fiscal austerity;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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