Optimal fiscal policy and debt management with sovereign default

My thesis focuses on the analysis of fiscal policy and debt management when governments can default on public debt. The research is organized in three chapters. In the first chapter I analyze optimal fiscal policy along the business cycle when lenders internalize the possibility of sovereign default. The result is a contribution to the literature of optimal fiscal policy and a theoretical explanation for pro-cyclical fiscal policies observed in non-G7 countries. Most papers on the topic regard this pattern as one of the reasons exacerbating volatility and reducing welfare in the developing world. However, in my thesis I show that if a government can default on public debt then a pro-cyclical fiscal policy turns out to be optimal, in the sense that it minimizes cyclical fluctuations in aggregate demand and output.; In Chapter 2 I generalize the results of chapter 1 to an economy that can produce non-traded goods and also can issue debt both in units of traded and non-traded goods. The purpose is to analyze optimal fiscal policy and debt management when liabilities are denominated in foreign currency, a factor that imposes severe limitations on counter-cyclical monetary and fiscal policies. The main conclusion is that the degree of optimal fiscal policy pro-cyclicality is increasing in the share of debt denominated in units of tradable goods. Moreover, the chapter shows that public debt denomination in domestic currency can serve as an expenditure-smoothing device.; Chapter 3 derives an optimal sovereign debt contract for the same economy as in chapter 1. The contract has several characteristics typical of debt restructuring agreements. First, it is triggered during combinations of low enough levels of economic activity and sufficiently high degrees of indebtedness. Second, it specifies a postponement of debt service payments and/or financing a country out of default, which is a typical arrangement through debt restructuring processes. Third, it imposes a fiscal adjustment that is smoothed-out over a sequence of periods. Fourth, it specifies lower equilibrium indebtedness than an economy that can commit not to default.