Working Paper: NBER ID: w26307
Authors: Javier Bianchi; Pablo Ottonello; Ignacio Presno
Abstract: What is the optimal fiscal policy response to a recession when the government is subject to sovereign risk? We study this question in a model of endogenous sovereign default with nominal rigidities. Increasing spending in a recession reduces unemployment, but exposes the government to a debt crisis. We quantitatively analyze this trade-off between stimulus and austerity and find that expanding government spending may be undesirable, even in the presence of sizeable Keynesian stabilization gains and inequality concerns. Consistent with these findings, we show that sovereign risk is a key driver of the fiscal procyclicality observed worldwide.
Keywords: Fiscal policy; Sovereign risk; Government spending; Economic stabilization
JEL Codes: E62; F34; F41; F44; H50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increasing government spending during a recession (E62) | Lower unemployment (J68) |
| Increasing government spending during a recession (E62) | Raises sovereign spreads (H63) |
| Lower unemployment (J68) | Mitigate immediate unemployment (J65) |
| Increasing government spending during a recession (E62) | Limit future fiscal space (E62) |
| High levels of debt (F34) | More severe recessions (F44) |
| Countries with high sovereign risk (F34) | More fiscal austerity during downturns (E62) |
| Optimal fiscal policy under conditions of sovereign risk (E62) | Procyclical fiscal stance (E62) |