Reconsideration of the “Domar condition” to check sustainability of budget deficit

Naoyuki Yoshino () and Hiroaki Miyamoto

Public Policy Review, 2021, vol. 17, issue 3, 1-12

Abstract: The Japanese economy is faced with the highest debt to GDP ratio due to the aging population. COVID-19 made the government spend huge amounts of money on medical expenses, cash transfers to SMEs, and so on. Budget deficits increased in many regions in the world. Fiscal sustainability is quite important not only among developed countries but also developing countries. As a condition for examining the financial stabilization “Domar condition” is commonly used. The Domar conditions compares “the interest rate” and “the economic growth rate.” If the former is smaller than the latter, the budget deficits will converge and the government deficits will be stabilized. Recently, the Central Bank of Japan started to purchase huge amounts of government bonds from the market and achieved “negative” interest rate. Paul Krugman says that Japan’s fiscal stability can be maintained if the central bank keeps interest rates negative, which is lower than the growth rate of the economy. In this paper, we explain that the Domar condition is derived by focusing only on the supply of government bonds and not considering the demand for government bonds. Next, including the demand for government bonds in the model, it will be shown that “outstanding stock of government bonds” and the interest rate sensitivity of the demand for government bonds should be compared by taking into account of both supply and demand for government bonds. The condition is applied to the case of Greece and Japan. This condition validates the national bankruptcy of Greece. It also shows why Japan is still sustained. The Domar condition applied is only to the U.S. where her currency is an international currency. In case of crisis, demand for government bonds will become larger and larger in the U.S. because demand comes from all over the world. On the other hand, many other counties face a decline in the demand for domestic currencies when facing a crisis. The sustainability of the government bond market should be checked by applying the condition shown in this paper to various countries including Japan.

Keywords: Domar conditions; fiscal sustainability conditions; supply and demand for government bonds (search for similar items in EconPapers)
JEL-codes: E62 E63 E65 (search for similar items in EconPapers)
Date: 2021
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