Fiscal Policy , Sovereign Risk , and Unemployment ∗

How should fiscal policy be conducted in the presence of default risk? We address this question using a sovereign default model with nominal rigidities. An increase in government spending during a recession stimulates economic activity and reduces unemployment. Because the government lacks commitment to future debt repayments, expansionary fiscal policy increases sovereign spreads, making the fiscal stimulus less desirable. We analyze the optimal fiscal policy and study quantitatively whether austerity or stimulus is optimal during an economic slump.