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Title: Time-Consistent Fiscal Policy in a Debt Crisis

Author(s): Neele Lisabet Balke and Morten O Ravn

Publication Date: November 2016

Keyword(s): austerity, debt crisis, inequality, Sovereign debt and Time-consistent fiscal policy

Programme Area(s): International Macroeconomics and Finance

Abstract: We analyze time-consistent fiscal policy in a sovereign debt model. We consider a production economy that incorporates feedback from policy to output through employment, features inequality though unemployment, and in which the government lacks a commitment technology. The government's optimal policies play off wedges due to the lack of lump-sum taxes and the distortions that taxes and transfers introduce on employment. Lack of commitment matters during a debt crises -- episodes where the price of debt reacts elastically to the issuance of new debt. In normal times, the government sets procyclical taxes, transfers and public goods provision but in crisis times it is optimal to implement austerity policies which minimize the distortions deriving from default premia. Could a third party provide a commitment technology, austerity is no longer optimal.

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Bibliographic Reference

Balke, N and Ravn, M. 2016. 'Time-Consistent Fiscal Policy in a Debt Crisis'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=11646