Incomplete Fiscal Rules with Imperfect Enforcement

This paper analyses the effect of limits on fiscal deficits when fiscal policy outcomes depend on automatic stabilizers and when fiscal rules lack perfect credibility. The model developed, which includes interactions between monetary and fiscal policy, provides theoretical support for existing arguments that fiscal rules contracted on a structural deficit will be welfare-enhancing relative to rules written on the actual deficit. The latter rules would result in a procyclical bias in fiscal policy, as well as a contractionary bias in monetary policy. Contrary to existing arguments, the model also suggests that rules written on the structural deficit may ultimately be more credible than those written on the actual deficit. The reason for this is that rules written on the actual fiscal deficit risk running into a credibility trap; higher marginal penalties will be necessary when initial credibility of enforcement is imperfect, but announcing a higher penalty for violating a fiscal rule can actually reduce credibility if the penalty is disproportionately large relative to the violation.