Does an active fiscal policy work under a high level of government debt?

Abstract

This article theoretically investigates the effect of expansionary fiscal shocks when the government faces a high debt-to-GDP ratio, under the regime of an active fiscal policy with a passive monetary policy in the terminology of Leeper (1991). We find that expansionary fiscal shocks become less effective when the government faces a high level of debt because the wealth effect on households decreases.

Keywords:

• active fiscal policy
• debt-to-GDP ratio
• wealth effect
• debt-to-tax ratio

JEL Classification:

• E63
• E32

Notes

¹ We abstract other shocks such as technology and monetary shocks to focus on the effect of fiscal shocks.

² In a Ricardian economy, Equation 8 implies a restriction on fiscal policy that is necessary and sufficient to sustain zero inflation in the steady state. In contrast, in a non-Ricardian economy, the present value of the net-of-interest government surplus is preset, and hence the price level and, in turn, inflation are determined.

³ This finding is consistent with Kim (2004).