Unit 4.4 - fiscal policy rules for the deficit and debt sustainability

Question 1

Debt dynamics

Answer 1

• Public debt accumulation arises because deficits must be financed
• Simplified setting: the government finances itself by issuing a single type of bond that matures by the end of the year

Question 2

What are sustainable public finances?

Answer 2

• if the expected future tax receipts cover expected future primary spending plus interest charges on outstanding debt
• The transversality condition is met: the present value of the expected debt ratio at time t tends to 0 as t tends to infinity
• The future debt can be high, but cannot grow faster than the difference between the interest rate and the growth rate
• The sum of the current debt and the present value of future primary expenditures equals the present value of future receipts

Question 3

European Commission indicators

Answer 3

1. Medium term fiscal sustainability indicator
   Goal: improve the structural primary balance to have no more than a 60% debt-to-GDP ratio in 2030
2. Long-term fiscal sustainability indicator
   - adjustment that would be required for the current structural primary balance to stabilise the debt-to-GDP ratio over an infinite horizon

Question 4

Fiscal space

Answer 4

• In reality it is not true that any level of debt can be sustained just by accumulating the right primary surplus every period
• A large and sustained primary surplus every period means making the living generation pay for the fiscal excesses of the previous ones; therefore, they are not politically sustainable.
• Fiscal space is a name for the difference between the primary surplus and the interest burned line. In other words, it’s the room available for a government to take various fiscal policy measures without putting debt sustainability at risk
• For low debt ratio levels, sustainability is not a concern
• As the debt ratio rises, however, a policy induced response appears: increase in the primary balance (towards surplus).
• Once the primary surplus starts getting large, this response weakens, again for political reasons, and eventually becomes muted
• This results in the S shaped curve