Committed to Flexible Fiscal Rules

Abstract

We study the implications of fiscal rules for macroeconomic stabilization when countries are hit by adverse exogenous shocks. Exploiting the unpredictability of natural disasters, we document that economies with a fiscal rule absorb these shocks better than those without: the responses of GDP and private demand are significantly higher. This difference is coupled with more expansionary fiscal policy and hinges on fiscal space. We analyze the interaction of rule flexibility and rule tightness in a quantitative model of sovereign default that exerts strong market discipline on governments conditional on disaster shocks. The results show potential welfare gains and a countercyclical fiscal response to adverse disaster shocks in the presence of tight rules and escape clauses.