Skip to main content

Fiscal Stimulus under Sovereign Risk

Working Paper 762 | Revised May 26, 2021

Download PDF

Authors

Javier Bianchi Senior Research Economist
Pablo Ottonello University of Michigan and NBER
Ignacio Presno Federal Reserve Board
Fiscal Stimulus under Sovereign Risk

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 observed fiscal procyclicality in the data.