Fiscal Policy, Sovereign Default, and Bailouts

Abstract

This paper examines …scal policy without commitment and the eects of bailout loans. We apply a simple closed econ- omy model with distortionary taxation, where the govern- ment decides discretionary between full debt repayment or costly default. The government tends to overborrow due to myopia, which aggravates welfare losses originating from the lack of commitment and provides a rationale to constrain sovereign borrowing. When the government favors default, bailout loans are oerred at a favorable price and conditional upon minimum primary surpluses. While the government's willingness to accept these oers decreases with the tight- ness of the …scal constraint, we …nd that household welfare is maximized only if the minimum surplus is su¢ ciently large. Yet, under welfare-enhancing bailout oers overborrowing is not resolved as the average stock of public debt tends to increase.