Economic Theory

, Volume 64, Issue 4, pp 657–673 | Cite as

Fiscal austerity during debt crises

  • Cristina Arellano
  • Yan Bai
Research Article


This paper constructs a dynamic model in which fiscal restrictions interact with government borrowing and default. The government faces fiscal constraints; it cannot adjust tax rates or impose lump-sum taxes on the private sector, but it can adjust public consumption and foreign debt. When foreign debt is sufficiently high, however, the government can choose to default to increase domestic public and private consumption by freeing up the resources used to pay the debt. Two types of defaults arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because of the government’s inability to raise tax revenues. Aggregate defaults occur even if the government could raise tax revenues; debt is simply too high to be sustainable. In a quantitative exercise calibrated to Greece, we find that our model can predict the recent default, but that increasing taxes would not have prevented it. In fact, increasing taxes would have made the recession deeper because of the distortionary effects of taxation.


Sovereign default Fiscal policy European debt crises 

JEL Classification

F3 F4 


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Copyright information

© Springer-Verlag Berlin Heidelberg (outside the USA) 2016

Authors and Affiliations

  1. 1.Federal Reserve Bank of Minneapolis, University of Minnesota, and NBERMinneapolisUSA
  2. 2.University of Rochester, and NBERRochesterUSA

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