This paper studies the main channels through which interest rate normalization has fiscal implications in the United States. While unexpected inflation reduces the real value of government liabilities, a rising policy rate increases government financing needs because of higher interest payments and lower real bond prices. After an initial decline, the real government debt burden rises even with higher tax revenues in an expansion. Given the current net debt-to-GDP ratio at around 80 percent, interest rate normalization leads to a negligible increase in the sovereign default risk of the U.S. federal government, despite a much higher federal debt-to-GDP ratio than the post-war historical average.

• Cover
• Contents
• 1. Introduction
• 2. The Model Setup
• 3. Calibration and Solution
• 4. Fiscal Limit Distributions
  • 4.1 The Baseline Distribution
  • 4.2 Alternative Distribution: Uncertain Future Fiscal Policies
• 5. Fiscal Implications of Rising Policy Rates
  • 5.1 An Endogenous Policy Rate Increase: the Baseline Analysis
  • 5.2 An Endogenous Policy Rate Increase against a High-Debt Level
  • 5.3 Interactions with a More Active Interest Rate Policy
  • 5.4 An Unexpected Acceleration in the Policy Rate Increase
• 6. Conclusion
• Appendix A. The Equilibrium System
• Appendix B. The Numerical Solution Method
• Tables
  • Table 1. Baseline Calibration
• Figures
  • Figure 1. Federal Government Debt, Interest Payments, and the Federal Funds Rate
  • Figure 2. Mandatory and Discretionary Spending of the Federal Government
  • Figure 3. Federal Income Tax Rates
  • Figure 4. Fiscal Limit Distributions for the Federal Government
  • Figure 5. Responses of an Endogenous Rising Policy Rate to a Positive Investment Efficiency Shock
  • Figure 6. Federal Funds Rate vs. Real Interest Rates on Treasury Bonds
  • Figure 7. Responses of an Endogenous Rising Policy Rate to a Positive Investment Efficiency Shock
  • Figure 8. Responses of an Endogenous Rising Policy Rate to a Positive Investment Efficiency Shock: Different Monetary Policy Activeness
  • Figure 9. Responses to an Exogenous Monetary Policy Shock
• References