Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/172903
Authors: 
Ferrière, Axelle
Karantounias, Anastasios G.
Year of Publication: 
2016
Series/Report no.: 
Working Paper 2016-6
Abstract: 
How should public debt be managed when uncertainty about the business cycle is widespread and debt levels are high, as in the aftermath of the last financial crisis? This paper analyzes optimal fiscal policy with ambiguity aversion and endogenous government spending. We show that, without ambiguity, optimal surplus-to-output ratios are acyclical and that there is no rationale for either reduction or further accumulation of public debt. In contrast, ambiguity about the cycle can generate optimal policies that resemble "austerity" measures. Optimal policy prescribes front-loaded fiscal consolidations and convergence to a balanced primary budget in the long run. This is the case when interest rates are sufficiently responsive to cyclical shocks; that is, when the intertemporal elasticity of substitution is sufficiently low.
Subjects: 
endogenous government expenditures
distortionary taxes
balanced budget
austerity
fiscal consolidation
martingale
ambiguity aversion
multiplier preferences
JEL: 
D80
E62
H21
H63
Document Type: 
Working Paper

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