Fiscal Rules and the Sovereign Default Premium

We use a sovereign default model to study the effects of introducing limits to the decision-making capabilities of governments-fiscal rules. We show that optimal limits to the debt level vary greatly across parameterizations of the model that deliver different levels of debt tolerance. In contrast, optimal limits to the sovereign premium paid by the government are very similar across parameterizations. Since levels of debt tolerance are difficult to identify and vary both across countries and over time, and political constraints often force common fiscal rule targets across countries, these findings indicate that sovereign-premium limits may be preferable to debt limits