Deficits, Public Debt Dynamics and Tax and Spending Multipliers

Abstract

Cutting government spending can increase the budget deficit at zero interest rates according to a standard New Keynesian model, calibrated with Bayesian methods. Similarly, increasing sales taxes can increase the budget deficit rather than reducing it. Both results suggest limitations of 'austerity measures'. At zero interest rates, running budget deficits can be either expansionary or contractionary depending on how they interact with expectations about long-run taxes and spending. The effect of fiscal policy action is thus highly dependent on the policy regime. A successful stimulus, therefore, needs to specify how the budget is managed not only in the short but also medium and long run.What is the effect of government spending cuts or tax hikes on the budget deficit? What is the effect of the budget deficit itself on short-run and long-run outcomes? Does the answer to these questions depend upon the state of the economy? Does it matter, for example, if the short-term nominal interest rate is close to zero and the economy is experiencing a recession? These are basic and fundamental questions in macroeconomics that have received increasing attention recently. Following the crisis of 2008, many governments implemented a somewhat expansionary fiscal policy but were soon confronted with large increases in public debt. That gave rise to calls for 'austerity', that is government spending cuts and tax hikes -aimed at decreasing government debt -a policy many claimed was necessary to restore 'confidence'. It follows that a model of the economy that makes sense of the policy discussion during this time has to account for the crisis and provide a role for fiscal policy, while also explicitly accounting for public debt dynamics. That is the objective of this study.The goal of this study is to analyse public debt dynamics in a standard New Keynesian dynamic stochastic general equilibrium (DSGE) model in a low interest rate environment. One of our main findings is that the rules for budget management change once the short-term nominal interest rate approaches zero in a way that is important for the debate on 'austerity' and 'confidence'. This shows up in our model in at least two ways. First, we show that once the short-term nominal interest rate hits zero, then cutting government spending or raising sales taxes has very different effects on deficits than under regular circumstances. Under regular circumstances, these austerity policies reduce the deficit roughly one to one. Once the nominal interest rate reaches zero, however, their effect becomes much smaller on the deficit. These policies may even increase rather than reduce the deficit. Second, we find that the economy is extraordinarily sensitive to expectations about the long-run at a zero interest rate. In particular, expectations about the future size of the government and future sales and/

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