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Fiscal Sustainability in Low Rate Environments

Paper Session

Friday, Jan. 7, 2022 3:45 PM - 5:45 PM (EST)

Hosted By: Society for Economic Dynamics
  • Chair: Hanno Nico Lustig, Stanford University

The Fiscal Theory of Price Level with a Bubble

Markus Konrad Brunnermeier
,
Princeton University
Sebastian A. Merkel
,
Princeton University
Yuliy Sannikov
,
Stanford University

Abstract

This paper incorporates a bubble term in the standard Fiscal Theory of the Price Level equation to explain why countries with persistently negative primary surpluses can have a positively valued currency and low inflation. It also provides two illustrative models with closed-form solutions in which the return on government bonds is below the economy’s growth rate. The government can “mine” the bubble by perpetually rolling over its debt. The welfare-maximizing bubble mining rate is independent of government spending, and additional spending needs should be financed exclusively through taxes. Despite the bubble, the price level remains determined provided government policy credibly promises primary surpluses off-equilibrium.

The Constraint on Public Debt When R < G but G < M

Ricardo Reis
,
London School of Economics

Abstract

With real interest rates below the growth rate of the economy, but the marginal product of capital above it, the public debt can be lower than the present value of primary surpluses because of a bubble premia on the debt. The government can run a deficit forever. In a model that endogenizes the bubble premium as arising from the safety and liquidity of public debt, more government spending requires a larger bubble premium, but because people want to hold less debt, there is an upper limit on spending. Inflation reduces the fiscal space, financial repression increases it, and redistribution of wealth or income taxation have an unconventional effect on fiscal capacity through the bubble premium.

Manufacturing Risk-free Government Debt

Zhengyang Jiang
,
Northwestern University
Hanno Nico Lustig
,
Stanford University
Stijn Van Nieuwerburgh
,
Columbia University
Mindy Z. Xiaolan
,
University of Texas-Austin

Abstract

Governments face a trade-off between insuring bondholders and insuring taxpayers against
output shocks. If they insure bondholders by manufacturing risk-free zero-beta debt, then
they can only provide limited insurance to taxpayers. Taxpayers will pay more taxes in bad
times regardless of whether output shocks are permanent or temporary. Permanent shocks
impute long-run output risk to the debt while transitory shocks impute interest rate risk, all of
which must be offset through taxation to keep the debt safe. Conversely, if governments insure
taxpayers against adverse macro shocks, then the debt becomes risky. Convenience yields on
government debt temporarily alleviate the trade-off.

A Goldilocks Theory of Fiscal Deficits

Atif Mian
,
Princeton University
Ludwig Straub
,
Harvard University
Amir Sufi
,
University of Chicago

Abstract

When an economy is close to the zero lower bound on nominal interest rates, government fiscal policy faces a trade-off: running deficits too low risks persistently low output but running deficits too high raises fiscal sustainability concerns. This study explores this trade-off in a tractable framework of dynamic fiscal policy, and it shows that fiscal policy can achieve an equilibrium within a Goldilocks zone, in which deficits are permanent but not too high, the nominal interest rate on government debt is lower than the economy’s growth rate, and deficits allow the economy to overcome weak demand in order to achieve its level of potential output. The size of the Goldilocks zone in the framework is tied to empirically observed moments in the data, which suggest for the United States that government debt to GDP ratios can reach a maximum of about 250% in the Goldilocks zone, but the maximum permanent government deficit is only about 2% of GDP. The framework also highlights the fragility of the Goldilocks zone: it can vanish in the face of a decline in potential GDP growth, a rise in aggregate demand, or a decline in income inequality.
JEL Classifications
  • E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
  • E4 - Money and Interest Rates