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Fiscal Multipliers and Public Debt Dynamics in Consolidations

Listed author(s):
  • Jocelyn Boussard
  • Francisco de Castro
  • Matteo Salto

The success of a consolidation in reducing the debt ratio depends crucially on the value of the multiplier, which measures the impact of consolidation on growth, and on the reaction of sovereign yields to such a consolidation. We present a theoretical framework that formalizes the response of the public debt ratio to fiscal consolidations in relation to the value of fiscal multipliers, the starting debt level and the cyclical elasticity of the budget balance. We also assess the role of markets confidence to fiscal consolidations under alternative scenarios. We find that with high levels of public debt and sizeable fiscal multipliers, debt ratios are likely to increase in the short term in response to fiscal consolidations. Hence, the typical horizon for a consolidation during crises episodes to reduce the debt ratio is two-three years, although this horizon depends critically on the size and persistence of fiscal multipliers and the reaction of financial markets. Anyway, such undesired debt responses are mainly short-lived. This effect is very unlikely in non-crisis times, as it requires a number of conditions difficult to observe at the same time, especially high fiscal multipliers.

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File URL: http://ec.europa.eu/economy_finance/publications/economic_paper/2012/ecp460_en.htm
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Paper provided by Directorate General Economic and Financial Affairs (DG ECFIN), European Commission in its series European Economy - Economic Papers 2008 - 2015 with number 460.

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Length: 35 pages
Date of creation: Jul 2012
Handle: RePEc:euf:ecopap:0460
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