Optimal fiscal policy when agents fear government default

Abstract

We derive the optimal fiscal policy for a government which is committed to honour its debts but faces investors which fear that a sovereign default might instead happen. We assume that investors are able to learn from new evidence, as in Marcet and Sargent (1989), so that they can correct over time their overly pessimistic view about government's creditworthiness. We show that in this economy, contrary to the prescriptions of standard models, a frontloaded fiscal consolidation after an adverse fiscal shock is optimal.