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Citation

Aguiar, Mark, and Manuel Amador. “Fiscal Policy in Debt Constrained Economies.” Journal of Economic Theory (2016) 161: 37-75.

Abstract

We study fiscal and monetary policy in a monetary union with the potential for rollover crises in sovereign debt markets. Member-country fiscal authorities lack commitment to repay their debt and choose fiscal policy independently. A common monetary authority chooses inflation for the union, also without commitment. We first describe the existence of a fiscal externality that arises in the presence of limited commitment and leads countries to over-borrow; this externality rationalizes the imposition of debt ceilings in a monetary union. We then investigate the impact of the composition of debt in a monetary union, that is the fraction of high-debt versus low-debt members, on the occurrence of self-fulfilling debt crises. We demonstrate that a high-debt country may be less vulnerable to crises and have higher welfare when it belongs to a union with an intermediate mix of high- and low-debt members, than one where all other members are low-debt. This contrasts with the conventional wisdom that all countries should prefer a union with low-debt members, as such a union can credibly deliver low inflation. These findings shed new light on the criteria for an optimal currency area in the presence of rollover crises.

BibTeX

@article{Aguiar201637,
	Author = {Aguiar, Mark and Amador, Manuel},
	Doi = {http://dx.doi.org/10.1016/j.jet.2015.11.002},
	Journal = {Journal of Economic Theory},
	Pages = {37-75},
	Title = {Fiscal policy in debt constrained economies},
	Url = {http://www.sciencedirect.com/science/article/pii/S0022053115001891},
	Volume = {161},
	Year = {2016}
}