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Unemployment, Sovereign Debt, and Fiscal Policy in a Currency Union

Pablo Ottonello, Ignacio Presno and Javier Bianchi
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Ignacio Presno: Universidad de Montevideo
Javier Bianchi: Federal Reserve Bank of Minneapolis

No 459, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: Is fiscal stimulus desirable when financing the government spending might imply a surge in borrowing costs and potentially lead to a sovereign debt crisis? This paper studies the optimal fiscal policy for a small open economy in a currency union in which the government cannot commit. In our two-sector dynamic model, the presence of downward nominal wage rigidity coupled with financial frictions may give rise to the welfare-improving effects of an expansionary fiscal policy. The government is confronted with a trade-off between the benefits of reducing unemployment and the financial costs of increasing external borrowing. A quantitative analysis is conducted to assess the desirability of austerity plans and stimulus programs in the context of the ongoing European debt crisis. In our theoretical framework, the response of the economic activity to government expenditures is highly nonlinear in the stock of external debt and the magnitude of the shocks.

Date: 2016
New Economics Papers: this item is included in nep-dge, nep-fdg, nep-mac and nep-opm
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