Research Discussion Papers, Bank of Finland
‘Some unpleasant fiscal arithmetic’: the role of monetary and fiscal policy in public debt dynamics since the 1970s
Abstract: Shocks to monetary and fiscal policy have played a major
role in public debt developments in the OECD countries since the mid-1970s.
According to the applied VAR approach, these shocks, taken together,
explained, on average, about half of the forecast error variation in the
debt to GDP ratio, while the share of shocks to GDP growth was close to 30
percent. In contrast, shocks to inflation and the debt ratio itself played
in most cases only a minor role. However, the inflation shocks were vital
in initiating the public debt problems, as the increase in actual
inflation, and particularly the persistence of high inflation expectations
in the 1980s, led to a prolonged period of high real interest rates.
Learning the implications of greater monetary discipline therefore gave
rise to ‘some unpleasant fiscal arithmetic’ which aggravated debt problems.
In most countries fiscal policy aimed at correcting the deterioration in
fiscal balances, but the progress was in most cases slow and delayed. It is
noticeable that public debt developments have been quite similar in both
the United States and the euro area despite differences in fiscal policy
and the role of the public sector. Shocks to GDP growth, inflation and
monetary policy, which have been more similar in both continents, explain
about two thirds of the forecast error variation of the debt to GDP ratio,
while shocks to fiscal policy explain about 20 percent.
Keywords: public debt dynamics; fiscal policy; monetary policy; VAR models; (follow links to similar papers)
JEL-Codes: C22; E62; H62; (follow links to similar papers)
46 pages, December 21, 2007
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