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Fiscal Stimulus under Sovereign Risk

Working Paper 762 | Revised May 26, 2021

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Javier Bianchi Monetary Advisor
Pablo Ottonello University of Michigan and NBER
Ignacio Presno Board of Governors of the Federal Reserve System
Fiscal Stimulus under Sovereign Risk


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 observed fiscal procyclicality in the data.

Published in: _Journal of Political Economy_ (Vol. 131, No. 9, September 2023, pp. 2328-2369),