ABSTRACT – This paper proposes a model to study how conditional lending and immediate liquidity provision affect incentives for fiscal adjustment in a country facing the risk of sovereign default. Conditional lending provides explicit incentives for fiscal adjustment but immediate liquidity provision is more effective in reducing liquidation costs. For some parameters, immediate liquidity provision induces fiscal adjustment and debt repayment, while conditional lending does not (and vice-versa). Incentives for fiscal adjustment are concave in the fraction of lending provided under conditionalities. A large cost of tight fiscal policy shifts the balance towards immediate liquidity provision.
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