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Federal Reserve Bank of Atlanta
FRB Atlanta Working Paper
Fiscal Austerity in Ambiguous Times
Axelle Ferrière
Anastasios G. Karantounias
Abstract

This paper analyzes optimal fiscal policy with ambiguity aversion and endogenous government spending. We show that, without ambiguity, optimal surplus-to-output ratios are acyclical and that there is no rationale for either reduction or further accumulation of public debt. In contrast, ambiguity about the cycle can generate optimally policies that resemble "austerity" measures. Optimal policy prescribes higher taxes in adverse times and front-loaded fiscal consolidations that lead to a balanced primary budget in the long-run. This is the case when interest rates are sufficiently responsive to cyclical shocks—that is, when the intertemporal elasticity of substitution is sufficiently low.


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Axelle Ferrière & Anastasios G. Karantounias, Fiscal Austerity in Ambiguous Times, Federal Reserve Bank of Atlanta, FRB Atlanta Working Paper 2016-6, 01 Mar 2016, revised 01 Jan 2018.
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Keywords: public consumption; intertemporal elasticity of substitution; balanced budget; austerity; fiscal consolidation; ambiguity aversion; multiplier preferences
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