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Fiscal Rules, Bailouts, and Reputation in Federal Governments

Alessandro Dovis, Rishabh Kirpalani

NBER Working Paper No. 23942
Issued in October 2017, Revised in September 2018
NBER Program(s):Economic Fluctuations and Growth, International Finance and Macroeconomics, Political Economy

Expectations of transfers by central governments incentivize overborrowing by local governments. In this paper, we ask if fiscal rules can reduce overborrowing if central governments cannot commit. We study a model in which the central government’s type is unknown and show that fiscal rules increase overborrowing if the central government’s reputation is low. In contrast, fiscal rules are effective in lowering debt if the central government’s reputation is high. Even when the central government’s reputation is low, binding fiscal rules will arise in the equilibrium of a signaling game.

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Document Object Identifier (DOI): 10.3386/w23942

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