Working Paper: NBER ID: w29129
Authors: Vadim Elenev; Tim Landvoigt; Patrick J. Shultz; Stijn van Nieuwerburgh
Abstract: Governments around the world have gone on a massive fiscal expansion in response to the Covid crisis, increasing government debt to levels not seen in 75 years. How will this debt be repaid? What role do conventional and unconventional monetary policy play? We investigate debt sustainability in a New Keynesian model with an intermediary sector, realistic fiscal and monetary policy, endogenous convenience yields, and substantial risk premia. When conventional monetary policy is constrained by the ZLB during an economic crisis, increased government spending and lower tax revenue lead to a large rise in government debt and raise the risk of future tax increases. We find that quantitative easing (QE), forward guidance, and an expansion in government discretionary spending all contribute to lowering debt/GDP ratio and reducing this fiscal risk. A transitory QE policy deployed during a crisis stimulates aggregate demand.
Keywords: Monetary Policy; Fiscal Capacity; Debt Sustainability; Quantitative Easing; Forward Guidance
JEL Codes: E1; E12; E13; E2; E31; E32; E37; E4; E42; E43; E44; E6; E62; E63; G12; G18; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased government spending (H59) | Higher government debt (H69) |
| Decreased tax revenues (H29) | Higher government debt (H69) |
| Higher government debt (H69) | Raises risk of future tax increases (H22) |
| Quantitative easing (QE) (C54) | Stimulates aggregate demand (E00) |
| Stimulates aggregate demand (E00) | Higher output and labor demand (J24) |
| Higher output and labor demand (J24) | Smaller increase in the debt-to-GDP ratio (H69) |
| Forward guidance + Quantitative easing (QE) (C54) | Maintain low long-term interest rates (E43) |
| Maintain low long-term interest rates (E43) | Reduces debt service burden on government debt (H63) |