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Fiscal Rules and Sovereign Default

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  • Laura Alfaro
  • Fabio Kanczuk

Abstract

Recurrent concerns over debt sustainability in emerging and developed nations have prompted renewed debate on the role of fiscal rules. Their optimality, however, remains unclear. We provide a quantitative analysis of fiscal rules in a standard model of sovereign debt accumulation and default modified to incorporate quasi-hyperbolic preferences. For reasons of political economy or aggregation of citizens' preferences, government preferences are present biased, resulting in over-accumulation of debt. Calibrating this parameter with values in the literature, the model can reproduce debt levels and frequency of default typical of emerging markets even if the household impatience parameter is calibrated to local interest rates. A quantitative exercise finds welfare gains of the optimal fiscal policy to be economically substantial, and the optimal rule to not entail a countercyclical fiscal policy. A simple debt rule that limits the maximum amount of debt is analyzed and compared to a simple deficit rule that limits the maximum amount of deficit per period. Whereas the deficit rule does not perform well, the debt rule yields welfare gains virtually equal to the optimal rule.

Suggested Citation

  • Laura Alfaro & Fabio Kanczuk, 2017. "Fiscal Rules and Sovereign Default," NBER Working Papers 23370, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:23370
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    10. Grossman, Herschel I & Van Huyck, John B, 1988. "Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation," American Economic Review, American Economic Association, vol. 78(5), pages 1088-1097, December.
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    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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