Optimal Fiscal Policy in the Post-Crisis World

Abstract

To contrast the severe global recession of 2009, governments in most advanced countries implemented expansionary fiscal policies leading to a steep increase in public debt. As economies recover, a critical choice is whether to stabilize debt at post-crisis levels, or to bring it down to pre-crisis levels. On this issue, advices of international institutions and those coming from mainstream economic theory are at odds. While international institutions have called for a substantial and fast debt reduction, optimal fiscal policy literature calls for debt stabilization. The aim of this paper is to provide a formal theoretical rationale to the policy advices of international institutions in a DSGE model (the workhorse of mainstream optimal fiscal policy theory). In particular, we consider a model in which a benevolent government has to choose taxes and debt in order to finance an exogenous stream of public expenditure. We compare the optimal fiscal plan in two contexts. In the first one households are fully confident about government solvency. In the second, households believe that there is a positive default probability which is positively related to the level of debt. While in the first framework a temporary bad shock translates into a permanent increase in the debt level, in the second one the increase in government debt is only temporary.