DP9163 | Sovereign default risk and commitment for fiscal adjustment

Publication Date

07/10/2012

JEL Code(s)

Keyword(s)

Programme Area(s)

Network(s)

Abstract

This paper studies fiscal policy in a model of sovereign debt and default. A time-inconsistency problem arises: since the price of past debt cannot be affected by current fiscal policy and governments cannot credibly commit to a certain path of tax rates, debtor countries choose suboptimally low fiscal adjustments. An international lender of last resort, capable of designing an implicit contract that coax debtors into a tougher fiscal stance via the provision of cheap (but senior) lending in times of crisis, can work as a commitment device and improve social welfare.