Elsevier

Economic Modelling

Volume 96, March 2021, Pages 257-276
Economic Modelling

Fiscal financing components in a simple model of policy interaction

https://doi.org/10.1016/j.econmod.2020.12.033Get rights and content

Highlights

  • In the US, the effect of fiscal financing components on public debt varied over time.

  • Previous studies do not calculate the components under different policy regimes.

  • Paper computes components’ distributions for active monetary-passive fiscal (M), and active fiscal-passive monetary (F).

  • Inflation, growth rate, and primary deficit play important roles under F.

Abstract

Post-Great Recession many advanced nations have experienced an unprecedented rise in debt-to-GDP ratios. Among other factors, increasing age-related spending can add to fiscal stress with a high peacetime debt-GDP ratio. Therefore, it is crucial to understand the factors that can affect the debt dynamics. Previous literature highlights the components affecting the debt-GDP ratio as nominal interest rate, inflation, growth rate, and primary deficit/surplus. However, the contribution of these financing components was calculated without any reference to policy regimes. This paper calculates the financing components and their distribution under two regimes: “active” fiscal and “passive” monetary policy (“F”) and “active” monetary and “passive” fiscal policy (“M”) using US data between 1942 and 2017. The results show that inflation, growth rate, and primary deficit have played essential roles in affecting the debt-GDP dynamics under regime F.

Introduction

After the Great Recession of 2007–2009, most advanced nations experienced a rise in debt-to-GDP ratios that matched the post-war years’ levels. Since it is a peace-time surge in the debt cause of concerns have been ways in which the debt level can be affected. Across time and continents there have been several ways of tackling the issue of debt.1 The debt-to-GDP ratio is affected by four components: nominal interest rate, inflation, growth rate, and primary deficit/surplus from the government budget constraint. Different components have affected the level of debt-to-GDP at various periods post-WWII for the United States. Whereas the US inflated away most of the debt in the 70s, primary surplus helped reduce the debt, during the late 90s. At other times it was the interest rate burden and primary deficit that added to the debt. Overall, in the post-war years, the economic growth rate helped the US come out of the debt burden (Hall and Sargent, 2011).

Different policy environments stand to affect fiscal financing components. In an early paper, Leeper (1993) shows how inflation, real debt, and taxes are affected by shocks hitting the economy under different policy regimes and demonstrates how the response of the macroeconomic variables vary depending on the policy regime in place.2 In the recent past the US government and Federal Reserve have undertaken steps to stabilize the economy to mitigate the effects of the Great Recession. The fiscal stimuli by the US treasury and the central bank's move to quantitative actions while maintaining near-zero nominal interest rate to stimulate the economy (Park, 2015) has implications for the evolution of debt-to-GDP ratio and the composition of the fiscal financing components (Leeper and Walker, 2011; Sims, 2013; Bianchi, 2012). For instance, the rise in debt-to-GDP ratio in the US immediately after the Great Recession is a result of the stimulus packages with a negligible role played by nominal interest rate. Thus fiscal and monetary policy interactions matter for the composition and adjustment of the fiscal financing components.3 Also, from the fiscal theory of the price level, a certain policy mix for monetary and fiscal policy leads to the determination of the price level and in turn has important bearing on the debt-to-GDP ratios.4

This paper contributes to the growing body of literature that analyzes the various channels affecting public debt. The main contribution of the paper is that it calculates the financing components under different policy regimes and provides the distribution of the components and the corresponding policy parameters. Notable earlier work in this area was done by Hall and Sargent (1997, 2011), where they undertake debt-GDP decomposition for the US into nominal interest rate, growth rate, inflation, primary deficit/surplus, and maturity structure of debt. However, they do not consider the financing components under different policy regimes. It is important to understand the role of policy regimes because it can be shown in a DSGE model with forward-looking agents that shocks to primary deficit can be absorbed by a surprise jump in the price level leading to “surprise inflation” resulting in revaluation of debt in regime “F” (“active” fiscal and “passive” monetary policy). This channel is absent in regime “M” (“active” monetary and “passive” fiscal policy) as the monetary authority being the “active” authority aggressively responds to inflation, leaving the adjustment to the fiscal authority, who passively adjusts spending and/or taxes to stabilize debt (Woodford, 2003).5

There are several advantages of undertaking such an analysis that calculates the financing components under different policy regimes. First, it helps to visualize how different components look like under each policy regime. Second, the distribution of policy parameters that lead to certain composition of the financing components become evident. Third, it also helps to see how the policy parameters have been across the subperiods and under each regime and such analysis lends itself easily to counterfactual exercise to understand the impact of certain policy parameter combination. This can help those in policy-making get a sense of how policy parameters can be manipulated to achieve a certain mix of the financing components. Finally, by comparing the simulation results to the data, it is possible to get a sense of the regime that might have been in place. This helps in understanding the relative importance of either fiscal or monetary policy in affecting the debt dynamics.

Analyzing economic variables under different policy regimes is now well established following early works by Leeper (1991, 1993). That an understanding of the underlying fiscal policy stance is important for some monetarist proposition was stressed in an even earlier work by Rao Aiyagari and Gertler (1985). How policy regime changes and agents’ beliefs can be used to explain the evolution of inflation in the US between mid-1950s to 2009 under different Fed chairman has been analyzed in Bianchi (2013). Besides, policy interactions are also important in answering questions such as whether a certain policy mix can help generate consumption growth following a government spending under price stickiness; or, understand the importance of policy co-ordination for an expansionary effect of a tax cut (Yang and Traum, 2010). Policy regimes are also crucial in understanding the effectiveness of fiscal stimulus as shown in Davig and Leeper (2011).

Unlike some previous work that analyzes policy regime changes, this paper assumes a particular policy regime (“M” or “F”) in place and then calculates the fiscal financing components under each policy regime. Also, a point of departure from earlier studies pertains to the sub-periods considered, which are, by US presidential years, as opposed to Fed chairman years.

In this paper I begin by looking at the fiscal financing components and how they affect the debt-to-GDP ratios for different sub-periods for the United States between 1942 and 2017. I construct a model that admits policy interactions where the fiscal authority sets taxes and spending and the monetary authority responds to inflation and sets the interest rate. From such a model I calculate the financing components under two policy regimes-“F” and “M”. Under each regime, I then undertake a prior predictive analysis to find out the distribution of the financing components and that of the associated policy parameters in each regime.

From the data for the United States between 1942 and 2017, I first calculate the financing components. Since the analysis is sensitive to the time periods chosen, for consistency, I choose the periods as per the US Presidential terms and consider 11 such periods. I find that inflation was an important factor during 1945–1953, growth rate played an important role between 1953 and 1969, nominal interest rate was an important factor for the period 1981–1993, and finally, primary deficit was a significant contributor during 2001–2017. Next, from the model I calculate the components from simulated data by calibrating the model to four subperiods-1945–1953, 1961–1969, 1981–1989, 2009–2017-under each policy regime. For the policy parameter values, I assign range of values that the relevant fiscal and monetary policy parameters can take following (Leeper et al., 2011).

The first time period, 1945–1953, marks the years when President Truman of the Democratic party was in office. During the initial years of the period economic expansion was underway, and inflation was high. In his first term as president (1945–1949), Truman's endeavor was to reduce the government spending by reducing military expenditure. The financing of the Korean War (1951–1953) was sought following a balanced budget approach, and there was a rise in taxes. Calibrating the model to this time period I find that in regime “F” inflation on an average turns out to be the main contributor, higher than in regime “M” and higher inflation was indeed a characteristic of the Truman years.

The second time period, 1961–1969, were the years when John F. Kennedy and his successor Lyndon B. Johnson were in office. It was during the 1960s that the US experienced an uninterrupted economic expansion. Riding on high productivity and efficiency, the US economy witnessed high growth rates during the 1960s. Also, this was when the Kennedy tax cut was in place so that primary surplus was not a feature of the period. There was a reduction in the debt-to-GDP ratio between 1961 and 1969 with growth rate playing a significant role followed by inflation. From the analysis I find that in both regimes growth rate is the main contributor, and given the contribution of other components, regime “F” appears to be the one mildly supported by the data.

During 1981–1989, President Ronald Reagan was in office, inheriting an economy that faced high inflation during the late 70s and the economy plunging into a recession in 1981. To counter the “Great Inflation” of the 70s (Bianchi, 2012), a tight monetary policy was put in place by Fed chairman Paul Volcker that eventually led to lower inflation rates during the period. The Reagan administration's economic policy leaned towards laissez faire that advocates little or no reliance on the government, and was influenced by supply-side economics. Following the Laffer curve principle, “Reaganomics” ushered in tax cuts to stimulate the economy so that the Economic Recovery Tax Act of 1981 was passed during this period. At the same time Reagan's international policy led to an expansion in the military expenditure. Data for the period reveals that the debt-to-GDP ratio rose, and the major contributing factor was the nominal interest rate. Calibrating the model to the period and subsequent analysis leads to results in regime “F” and “M” from which no conclusive statement can be made as the results did not match the data. Contrary to data none of the regimes show nominal interest rate to be the main contributor although the contribution of nominal interest rate is observed to be higher in “M” compared to “F”.

Finally, the period 2009–2017 marks the Presidential years of Barrack Obama, a period immediately after the US economy came out of the “Great Recession”. This was when the economy was recovering and the average growth rate was a little over one percent. Inflation rate was low, and the Fed maintained a nominal interest rate that was near zero in a fit to stimulate the economy. To help stimulate the economy, the Obama administration undertook measures in the form of stimulus packages that led to a substantial rise in the deficit. This is reflected in the data whereby primary deficit emerges as the main contributor in affecting the rise in debt-to-GDP ratio during this period. From the analysis I find that favourable cases appear only in regime “F”. Like in the data, primary deficit turns out to be the most important contributor.

The analysis shows that during the subperiods 1945–1953 and 2009–2017, the results from regime “F” match the pattern observed in data. The corresponding policy parameter values also corroborates with the events unfolding during the subperiods under review substantiating the view that the regime in place may have been “F”. Overall, I find that if the regime is “F” either of the components-inflation and primary deficit play important roles in affecting the debt-GDP ratio. Interestingly, growth rate as an important component can occur under both regimes as during the period 1961–1969. However, comparing with data it appears that during the Kennedy-Johnson years there is only mild support from data that the regime may have been “F”. For the subperiod 1981–1989 one reason why no substantial results emerge could be because the regime in place may not have been “M” or “F”. Therefore, inflation, growth rate, and primary deficit can play important roles in regime F, thereby, making fiscal policy relatively more important in affecting the debt dynamics.

Post-Great Recession, there is a renewed interest in the understanding of the effect of fiscal policy in stimulating the economy. In so doing it is important to understand the stance of monetary policy (Leeper et al., 2011). This is especially important in light of the stimulus packages like ARRA in the US and the efforts undertaken by the European Union to revive the economies. Such concerns are also relevant to address the question of fiscal financing for an emerging economy such as Korea (Hur and Lee, 2017).

The rest of the paper is organized as follows. Section 2 presents the results from the debt decomposition for the US between 1942 and 2017 for different time periods. In section 3, I construct a model with policy interaction followed by a discussion of the prior predictive method. The fiscal financing components from the model under different time period calibration is taken up in section 4 with 4.1 Period:1945–1953, 4.3 Period:1961–1969, 4.5 Period:1981–1989, 4.7 Period:2009–2017 presenting the results from the simulations. Section 4.9 discusses policy regimes and finally, section 5 concludes.

Section snippets

Fiscal financing components in the US: 1942–2017

From the government budget constraint between time periods t and (t − τ) the difference between the debt-to-GDP ratio can be decomposed into nominal interest rate, inflation and output growth rate (as a share of debt-to-GDP) and primary deficit/surplus (as a share of GDP) leading to the following equation6:btbtτ=i=0τ1(rtiπtigti)bt1istiwhere, bt is real debt as share of real GDP, rt is the nominal interest rate, πt is the

Simple model of policy interaction

In this section I consider a simple economy consisting of representative households, a fiscal authority that imposes lump-sum tax, spends and issues bonds, and a monetary authority that sets the nominal interest rate and responds to inflation.

Fiscal financing components from model

In this section I present results from the simulation exercises. As observed in the data analysis various components have played significant roles at various times between 1942 and 2017. I choose the periods when any one of the financing components, nominal interest rate, inflation, growth rate, primary surplus/deficit played an important role. Accordingly, I choose the periods 1945–1953, 1961–1969, 1981–1989 and 2009–2017 when inflation, growth rate, nominal interest rate, and primary deficit

Conclusion

In the aftermath of the Great Recession 2007–2009 there has been a surge in the debt-to-GDP ratio for almost all advanced nations. The debt overhang is a peacetime phenomenon that resembles the levels that the world experienced post WWII. There are various ways of reducing the debt burden and history is witness to the myriad ways sovereigns have attempted it and been able to successfully unburden the debt. However, from the government budget constraint between any two time periods instruments

Declaration of competing interest

The authors declare that they have no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.

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  • Cited by (0)

    I would like to thank my advisor Prof. Eric Leeper for his guidance and insightful comments on the paper. My thanks to Nora Traum for sharing the matlab code from one of her papers. I would also like to thank Prof. Walker, Prof. Escanciano and Prof. Hatchondo for their comments on the paper. Also, special thanks to the editor of Economic Modelling (Prof. Sushanta Mallick) and two anonymous referees whose thoughtful feedback on the paper was immensely helpful. I would also like to thank Sisir Debnath for all the help and support. Rest of the errors are all mine.

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