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Fiscal Rules and Discretion with Risk of Default

Author

Listed:
  • Felli, Chiara
  • Piguillem, Facundo
  • Shi, Liyan

Abstract

We study optimal fiscal rules when present-biased governments can default on their debt. Beyond their tendency to overaccumulate debt, they exhibit biases in default incentives. Depending on the severity of the bias and the cost of default, governments may either over-default, inefficiently defaulting at low debt, or under-default, retaining excessively high debt. The latter arises from a "clean-slate externality": governments fail to internalize the future benefits of offloading debt. Balancing the commitment to not overspend with the flexibility to react to shocks, it is optimal to complement spending rules with default rules that either forbid or force default.

Suggested Citation

  • Felli, Chiara & Piguillem, Facundo & Shi, Liyan, 2021. "Fiscal Rules and Discretion with Risk of Default," CEPR Discussion Papers 16211, Centre for Economic Policy Research.
    • Handle: RePEc:cpr:ceprdp:16211
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    File URL: https://cepr.org/publications/DP16211
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    Keywords

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    JEL classification:

    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H1 - Public Economics - - Structure and Scope of Government
    • H6 - Public Economics - - National Budget, Deficit, and Debt

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