A fiscal reaction function to debt and the cycle is built on a buffer-stock model for the government. This model inspired by the buffer-stock model of the consumer (Deaton 1991; Carroll 1997) includes a debt limit instead of the Intertemporal Budget Constraint (IBC). The IBC is weak (Bohn, 2007), a debt limit is more realistic as it reflects the risk of losing market access. This risk increases the welfare cost of fiscal stimulus at high debt. As a result, the higher the debt, the less governments should smooth the cycle. A larger reaction of interest rates to debt and higher hysteresis magnify this interaction between the debt level and the appropriate reaction to shocks. With very persistent shocks, the appropriate reaction to negative shocks in highly indebted countries can even be procyclical.

• Cover
• Contents
• Abstract
• I. Introduction
  • A. How the Fiscal Stance Should Change with the Debt Level
  • B. Modelling the Trade-off between Stabilization and Market Access
• II. A Simple Model Shows Some Fiscal Implications of the Risk of Losing Market Access
  • A. A Stochastic Model of the Government without a Debt Limit
  • B. The Buffer-stock Model of the Government with a Debt Limit
• III. A more realistic model with feedback effects
  • A. The maximization problem
  • B. Output and fiscal policy
• IV. The Appropriate Fiscal Stance: Results
  • A. Baseline Results
  • B. Hysteresis Can Magnify the Stabilization-debt Nexus
  • C. The Magnifying Role of Interest Rate Reaction to Debt
  • D. Sensitivity to Higher Growth Rate
  • E. The Fiscal Multiplier
  • F. Automatic Stabilizers
  • G. The Persistence of Shocks
  • H. The Size of Shocks
  • V. Conclusion
• References
• Annexes
  • Annex 1. Analytic Results with the Simple Model
  • Annex 2. The Gap as a Function of the Underlying Shock and the Structural Primary Balance
  • Annex 3. Calibration
• Tables
  • Table 1. Baseline Calibration
• Figures
  • Figure 1. Primary Balance with and without Debt Limit
  • Figure 2. The Equilibrium between the Primary Balance and the Output Gap
  • Figure 3. Baseline Fiscal Reaction Function to Debt
  • Figure 4. Fiscal Reaction Function and Hysteresis
  • Figure 5. Fiscal Reaction Function and the Effect of Debt on the Risk Premium
  • Figure 6. Fiscal Reaction Function and a Non-linear Effect of Debt on the Risk Premium
  • Figure 7. Fiscal Reaction Function and Potential Growth
  • Figure 8. Fiscal Reaction Function and the Fiscal Multiplier
  • Figure 9. Reaction to Output Shocks and the Fiscal Multiplier
  • Figure 10. Fiscal Reaction Function and the Size of Automatic Stabilizers
  • Figure 11. Fiscal Reaction Function and Lower Shock Persistence
  • Figure 12. Fiscal Reaction Function and Higher Shock Persistence
  • Figure 13. Fiscal Reaction Function and Shock Size