Sovereign debt, fiscal policy, and macroeconomic instability

Francesco Carli and Leonor Modesto

Journal of Public Economic Theory, 2022, vol. 24, issue 6, 1386-1412

Abstract: We study the relation between capital accumulation, fiscal policy, and sovereign debt dynamics in a small open economy. The government maximizes spending, facing borrowing constraints and a conditionality requirement. Debt dynamics are forward looking, being driven by the endogenous borrowing constraint. Current debt is determined by expectations about the government's ability to finance itself in the future, opening the room for indeterminacy. If the government believes it may issue more debt next period, the borrowing constraint relaxes, and current debt increases. The government invests more in productive activities, generating a boom which increases tax revenues. However, as this increase does not repay the additional debt, the government will issue more debt next period, confirming initial expectations. To exclude explosive trajectories, tax revenues must increase enough to repay the outstanding debt and reduce future debt emission. This is possible only with a sufficiently procyclical tax rate. In this case, if productive externalities are large enough, the economy exhibits local and global indeterminacy, as steady‐state multiplicity is also obtained. Avoiding sufficiently procyclical tax rates, the government can prevent local and global fluctuations driven by self‐fulfilling volatile expectations. This differs from the general wisdom that procyclical tax rates should be used for stabilization.

Date: 2022
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