Stimulus vs. Austerity vs. Default

There is an ongoing debate about austerity and stimulus in the Euro zone. Moreover, given the fiscal and financial problems in the region, a default has appeared likely at times. In this context, this paper develops a dynamic stochastic quantitative model of sovereign default with fiscal policy, which captures the most salient features of the recent fiscal and debt situation in the Euro zone. In this setting, this highlights the economic nature of the decision to default, the key role of official aid in avoiding such event and, thus, improving the overall economic outlook.