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Self-fulfilling debt crises, fiscal policy and investment

Galli, Carlo (2019) Self-fulfilling debt crises, fiscal policy and investment. CFM discussion paper series (CFM-DP2019-04). Centre For Macroeconomics, London School of Economics and Political Science, London, UK.

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Abstract

This paper studies the circular relationship between sovereign credit risk, government fiscal and debt policy, and output. I consider a sovereign default model with fiscal policy and private capital accumulation. I show that, when fiscal policy responds to borrowing conditions in the sovereign debt market, multiple equilibria exist where the expectations of lenders are self-fulfilling. In the bad equilibrium, pessimistic beliefs make sovereign debt costly. The government substitutes borrowing with taxation, which depresses private investment and future output, increases default probabilities and verifies lenders’ beliefs. This result is reminiscent of the European debt crisis of 2010-12: while recessionary, fiscal austerity may be the government best response to excessive borrowing costs during a confidence crisis.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.centreformacroeconomics.ac.uk/Home.aspx
Additional Information: © 2019 The Author
Divisions: Centre for Macroeconomics
Subjects: H Social Sciences > HG Finance
H Social Sciences > HJ Public Finance
JEL classification: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy
E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy Formation, Macroeconomic Aspects of Public Finance, Macroeconomic Policy, and General Outlook > E62 - Fiscal Policy; Public Expenditures, Investment, and Finance; Taxation
F - International Economics > F3 - International Finance > F34 - International Lending and Debt Problems
Date Deposited: 05 Jun 2019 09:24
Last Modified: 26 Jan 2020 00:30
URI: http://eprints.lse.ac.uk/id/eprint/100942

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