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Fiscal rules and the sovereign default premium

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  • Juan Carlos Hatchondo
  • Leonardo Martinez
  • Francisco Roch

Abstract

We find the optimal target values for fiscal rules and measure their aggregate effects using a model of sovereign default. We calibrate the model to an economy that pays a significant sovereign default premium when the government is not constrained by fiscal rules. For different levels of the default premium, we find that a government with a debt of 38 percent of trend income (typical in the case studied here) chooses to commit to a debt ceiling of 30 percent of trend income that starts being enforced four years after its announcement. This rule generates expectations of lower future indebtedness, and thus it allows the government to borrow at interest rates significantly lower than the ones it pays without a rule. We also study the case in which the government conducts a voluntary debt restructuring to capture the capital gains from the increase in its debt market value implied by the existence of a fiscal rule. In this case, the government is found to choose instead a debt ceiling of 25 percent of trend income that starts being enforced less than two years after its announcement. After the imposition of the debt ceiling, lower debt levels allow the government to implement a less procyclical fiscal policy that reduces consumption volatility. However, the government prefers a procyclical debt ceiling that implies a larger reduction of the default probability at the expense of a higher consumption volatility.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 12-01.

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Date of creation: 2012
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Handle: RePEc:fip:fedrwp:12-01

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Keywords: Business cycles ; Financial markets ; Financial institutions;

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References

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Cited by:
  1. Beetsma, Roel & Mavromatis, Kostas, 2014. "An analysis of eurobonds," Journal of International Money and Finance, Elsevier, vol. 45(C), pages 91-111.
  2. Osterloh, Steffen & Heinemann, Friedrich & Kalb, Alexander, 2013. "Sovereign risk premia: The link between fiscal rules and stability culture," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 80043, Verein für Socialpolitik / German Economic Association.
  3. Leonardo Martinez & Cesar Sosa Padilla & Juan Hatchondo, 2012. "Debt dilution and sovereign default risk," 2012 Meeting Papers 974, Society for Economic Dynamics.
  4. Juan Carlos Hatchondo & Leonardo Martinez & Cesar Sosa Padilla, 2013. "Voluntary Sovereign Debt Exchanges," Department of Economics Working Papers 2013-13, McMaster University.
  5. Juan Carlos Hatchondo & Leonardo Martinez, 2012. "On the benefits of GDP-indexed government debt: lessons from a model of sovereign defaults," Economic Quarterly, Federal Reserve Bank of Richmond, issue 2Q, pages 139-157.
  6. Juan Carlos Hatchondo & Leonardo Martinez, 2013. "Sudden Stops, Time Inconsistency, and the Duration of Sovereign Debt," International Economic Journal, Taylor & Francis Journals, vol. 27(2), pages 217-228, June.
  7. repec:fip:fedreq:y:2012:i:2q:p:139-157:n:vol.98no.2 is not listed on IDEAS
  8. Joy, Mark, 2012. "Sovereign default and macroeconomic tipping points," Research Technical Papers 10/RT/12, Central Bank of Ireland.
  9. Gustavo Adler & Sebastian Sosa, 2013. "External Conditions and Debt Sustainability in Latin America," IMF Working Papers 13/27, International Monetary Fund.
  10. Daniel Kapp, 2012. "The optimal size of the European Stability Mechanism: A cost-benefit analysis," DNB Working Papers 349, Netherlands Central Bank, Research Department.

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