Fiscal Policy, Sovereign Risk, and Unemployment

How should fiscal policy be conducted in the presence of default risk? We addressthis question using a sovereign default model with downward wage rigidity. Anincrease in government spending during a recession stimulates... [ view full abstract ]

How should fiscal policy be conducted in the presence of default risk? We address
this question using a sovereign default model with downward wage rigidity. An
increase in government spending during a recession stimulates economic activity and reduces unemployment. Because the government lacks commitment to future debt repayments, expansionary fiscal policy increases sovereign spreads making the fiscal stimulus less desirable. We analyze the optimal fiscal policy and study quantitatively whether austerity or stimulus is optimal during an economic slump.