Optimal fiscal policy with sovereign default

Procyclicality of \u85scal policy in developing countries is a well-documented phenomenon which is at odds with neoclassical and Keynesian policy prescrip-tions. The current paper investigates this issue by solving the optimal \u85scal policy problem of a small open economy government when interest rates on ex-ternal debt are endogenous. Given an incomplete asset market, endogeneity is achieved by taking away the governments ability to commit to repaying its exter-nal obligations. When calibrated to Argentina, the model generates procyclical government spending and countercyclical labour income tax rates. Moreover, the models implications for key business cycle moments are in line with the data