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Myopic governments and welfare-enhancing debt limits

  • Rieth, Malte

This paper studies welfare effects of a soft borrowing constraint on sovereign debt. The constraint is modeled as a proportional fine per unit of debt in excess of a specified reference value, resembling features of the Stability and Growth Pact. Sovereign debt is the result of myopic fiscal policy. It reduces welfare in the absence of lump-sum taxes. The paper shows that the borrowing constraint enhances welfare by reducing long run debt. In an economy calibrated to a generic OECD country, the maximum attainable welfare gain of debt consolidation, which is induced by imposing the optimally parameterized constraint, amounts to 0.5% in terms of consumption. The short run welfare costs of the constraint, which arise from restricting the use of debt to smooth taxes, are quantitatively negligible.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 38 (2014)
Issue (Month): C ()
Pages: 250-265

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Handle: RePEc:eee:dyncon:v:38:y:2014:i:c:p:250-265
Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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