Fiscal rules and the sovereign default premium

We present a sovereign default model that can mimic salient features in a typical small open economy. We then use the model to study the effects of introducing limits to the decision-making ability of governments' fiscal rules. We show that optimal limits to the debt level vary greatly across parameterizations of the model. In contrast, optimal limits to the sovereign premium the government can pay while increasing its debt are very similar across parameterizations. Given the uncertainty about model parameter values and political constraints that may force common fiscal rule targets across economies, these findings indicate that sovereign-premium limits may be preferable over debt limits. We also show that rules should not necessarily promote a countercyclical fiscal policy. Benets from imposing a rule arise even if governments are not shortsighted.