Optimal Fiscal Policy and Sovereign Debt: A signaling model

This paper analyzes the optimal use of fiscal policy and sovereign debt repayment as signals in an asymmetric information environment. It shows that the presence of government private information could turn an optimal full-information countercyclical fiscal policy into a pro-cyclical one that exacerbates the cycle. This may occur if the effect of aggregate shocks on the signaling properties of fiscal policy is not symmetric across states. An alternative channel for this result could be the impact of the cycle on the government borrowing constraints. These two mechanisms provide a rational for the observed pro-cyclicality in fiscal policy in emerging countries where both private information and sovereign borrowing constraints are more pervasive than in developed economies