Risk assessment under a nonlinear fiscal policy rule

Abstract

In the aftermath of the recent debt crisis, many countries are implementing nonlinear fiscal policy rules, whereby the government's responsiveness to debt strengthens at higher levels of debt. This paper examines how a nonlinear fiscal policy rule affects the possibility of future insolvency in a small open economy. We find that (1) the criteria for a nonlinear fiscal rule to eliminate explosive behavior should be tighter than the ones proposed by Bohn (1998); (2) a country that adopts a nonlinear fiscal rule could substantially reduce the probability of a solvency crisis; and (3) a nonlinear fiscal rule allows a country to reduce the possibility of insolvency without large initial responsiveness. (JEL C63, E62, E63, F34, H63)