International Finance Discussion Papers (IFDP)

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September 2019

Fiscal Stimulus under Sovereign Risk

Javier Bianchi, Pablo Ottonello, and Ignacio Presno

Abstract:

The excess procyclicality of fiscal policy is commonly viewed as a central malaise in emerging economies. We document that procyclicality is more pervasive in countries with higher sovereign risk and provide a model of optimal fiscal policy with nominal rigidities and endogenous sovereign default that can account for this empirical pattern. Financing a fiscal stimulus is costly for risky countries and can render countercyclical policies undesirable, even in the presence of large Keynesian stabilization gains. We also show that imposing austerity can backfire by exacerbating the exposure to default, but a well-designed "fiscal forward guidance" can help reduce the excess procyclicality.

Keywords: Fiscal Stabilization Policy, Sovereign Default, Procyclicality

DOI: https://doi.org/10.17016/IFDP.2019.1257

PDF: Full Paper

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Last Update: January 09, 2020