Expansionary fiscal rules under sovereign risk

We study fiscal rules in a sovereign default model with private capital accumulation and long-term debt. Their adoption strengthens public finances and increases long-run income by mitigating two distortions: debt dilution and underinvestment. In the short run, however, the economy experiences a costly transition where consumption and investment drop to finance debt reduction. To study this tradeoff, we calibrate the model to Argentina and evaluate three rules: a debt limit, a deficit limit, and a dual rule combining both. The deficit limit is preferred only when implemented at high debt levels because it features smoother debt reduction but imposes strict discipline in all states. Otherwise, gains are highest under the dual rule that combines the flexibility of debt limits at low levels with the discipline of deficit limits at higher levels. Results are robust to alternative formulations for capital accumulation and stronger in the presence of political myopia.