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.
Ferriere, Axelle, and Anastasios G. Karantounias.
"Fiscal Austerity in Ambiguous Times."
American Economic Journal: Macroeconomics,
Criteria for Decision-Making under Risk and Uncertainty
Business Fluctuations; Cycles
Interest Rates: Determination, Term Structure, and Effects
Taxation and Subsidies: Efficiency; Optimal Taxation
National Budget; Budget Systems
National Debt; Debt Management; Sovereign Debt