The Debt Capacity of a Government

Bernard Dumas, , and Chunyu Yang

No 16687, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: In a deterministic overlapping-generations economy with production and physical capital, the price of debt can be positive without any budget surpluses being in the offing, because debt incorporates a rational bubble. Yet the dynamics of debt remain a function of the dynamics of the primary budget deficit. As a way to study their joint behavior, we endogenize a structural deficit in the form of an underfunded social-security scheme. We define debt capacity as the level of debt that can be just sustained without a change of policy all the way to an unstable steady state. When it starts below the capacity, the debt converges to a stable steady state, in which the bubble is sustained. Above capacity the bubble unravels and the deficit cannot be financed. In several realistic scenarios occurring in economies, we calculate the needed policy response, which is the true "fiscal cost" of exceeding debt capacity.

Keywords: Debt capacity; Fiscal policy; Asset market bubbles; Social security sustainability (search for similar items in EconPapers)
JEL-codes: E13 E43 E44 E50 E62 E63 H30 H62 H63 H68 (search for similar items in EconPapers)
Date: 2021-11
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