Session 19: Fiscal Sustainability

We study how debt news shapes firms’ inflation expectations in a monetary union. In an active-control experiment, German firms receive optimistic or pessimistic projections of France, Italy, and Spain’s debt-to-GDP ratios. Pessimistic news raises debt beliefs and increases one- and three-year inflation expectations, with no detectable effect at five years. The response is driven by low-trust firms and by firms expecting relatively low ECB policy rates. A salient German debt-financed fiscal shock generates no comparable response. Within a Fisherian framework, the evidence suggests that debt news becomes inflationary when firms perceive incomplete fiscal backing and expect monetary accommodation.

Do stimulus checks—one-off, deficit-financed and lump-sum payments from the government to households—boost the economy? We study a natural experiment: payments to U.S. veterans in the late 1940s and 1950s that mimic stimulus checks. With newly digitized data, we show that these payments led to a temporary increase in transfers and a large, persistent increase in consumption. The transfer multiplier, defined as the cumulative response of consumption to the cumulative response of transfers, reaches 1 after six months and over 2 after a year. We calibrate a heterogeneous-agent New Keynesian model to match our estimates. Standard specifications struggle to reproduce the persistent response of consumption, pointing to a role for imperfect expectations with underreaction on impact and overreaction at longer horizons.

We provide direct evidence on how the public expects the government to satisfy its intertemporal budget constraint. Using a large representative survey of U.S. households, we elicit beliefs about how the government will finance both existing debt and newly issued debt due to fiscal policy shocks. On average, respondents expect only 45% of current debt to be repaid through future primary surpluses. A substantial 23% is expected to be rolled over indefinitely without ever generating surpluses, as if sustained by a bubble, and 11% to be inflated away. Respondents view a comparableshare of newly issued debt that finances military spending and household transfer shocks as similarly unfunded. These beliefs are state-dependent: at a debt-to-GDP ratio of 150%, the perceived bubble share shrinks from 23% to 15%. When we pose the same questions to academic and policy economists, experts perceive an even larger bubble component (37% versus 23%). Calibrated to match our measured financing beliefs, a New Keynesian model in which debt can be valued without surpluses amplifies the transmission of fiscal shocks, raising the government spending multiplier by 0.2.

How resilient is the U.S. Treasury market in the face of macroeconomic turmoil, contracting foreign demand, or reductions in the Fed’s balance sheet? We develop a framework to quantitatively assess the Treasury market’s resilience to shocks by integrating a granular sector- level Treasury demand system with risk-averse arbitrageurs. Our model highlights how Treasury holders’ heterogeneous demand for duration and sensitivity to macroeconomic conditions interact with arbitrageurs’ expectations to shape Treasury market resilience. Quantitatively, we find that foreign demand contractions of identical dollar amounts have highly heterogeneous impacts on Treasury yields, depending on the duration of foreign investor holdings and how they respond to changes in economic states. Moreover, inflationary shocks significantly reduce Treasury values beyond the expectations hypothesis in that the yield responses to higher inflation expectations are amplified through foreign official demand retrenchment that raises long- term yields further. Finally, the Treasury market is more resilient to Quantitative Tightening (QT) shocks if implemented as a permanent level reduction but significantly less resilient to QT as a loss of state-contingent Fed support. These exercises reveal that Treasury market resilience is shaped by the composition of Treasury investors’ demand, shock persistence, and policy rule designs, not shock size alone.

Policymakers often cite the risk that inflation expectations might “de-anchor” as a key reason for responding forcefully to inflationary shocks. We develop a model to analyze this trade-off and to quantify the benefits of stable long-run inflation expectations. In our framework, households and firms are imperfectly informed about the central bank’s objective and learn from its policy choices. Recognizing this interaction, the central bank raises interest rates more aggressively after adverse supply shocks and accepts short-run output costs to secure more stable inflation expectations. The strength of this reputation channel depends on how sensitive long-run inflation expectations are to surprises in interest rates. Using high-frequency identification, we estimate these elasticities for emerging and advanced economies and find large negative values for Brazil. We fit our model to these findings and use it to quantify how reputation building motives affect monetary policy decisions, and the role of central bank's credibility in promoting macroeconomic stability.

How does the fiscal framework affect the central bank’s ability to stabilize output and inflation? The textbook answer, which assumes Ricardian households, recommends that fiscal adjustment should be fast enough to allow for monetary dominance. We instead argue that, with non-Ricardian households, the central bank may indeed welcome slow, or even no, fiscal adjustment. On the demand side, slow fiscal adjustment helps stabilize aggregate spending; on the supply side, it eases tax distortions, improving the output-inflation trade off. And while the first channel favors slow fiscal adjustment only when the business cycle is dominated by demand shocks, the second channel extends this preference to supply shocks. A quantitative exercise affirms our lessons in the U.S. context, with the central bank preferring virtually no fiscal adjustment over the business cycle.

The conventional view holds that active monetary policies require fiscal accommodation, and vice versa. We find a new possibility in international economy: a hegemon country can simultaneously pursue active monetary and fiscal goals, if foreign policymakers are willing to accommodate. For example, the hegemon can tighten monetary policy without domestic fiscal support, if foreign countries align their monetary stance and provide fiscal backing. Backed by foreign surpluses, the hegemon can also run deficits without domestic monetary support. In this regime, external adjustments play a key role in domestic policy coordination, and U.S. policy effectiveness depends critically on its international position.

U.S. public debt levels appear unsustainable, yet strong investor demand keeps interest rates on Treasuries low. Policymakers face a trade-off: Reduce long-run tax burdens through debt reduction or satiate safe asset demand through debt expansion. To quantify this trade-off, I solve for the optimal Ramsey policy of a government that issues safe assets (i.e., risk-free and liquid), raises distortionary taxes, and insures against aggregate risk. The calibrated model matches historical U.S. debt policy. Despite low interest rates, the model shows that recent crises were overly debt-financed and recommends reducing the debt to 65% of GDP over the next 10 years.

This paper studies how government bond supply affects asset prices. I exploit a timing separation in the UK fiscal framework together with high-frequency identification. The identification is based on movements in long gilt futures around UK Debt Management Office announcements, especially those released immediately after Budget speeches by the Chancellor of the Exchequer. These speeches disclose fiscal news about spending, taxes, deficits, and consolidated public debt, but not the exact quantity of gilts to be issued. The subsequent DMO announcement therefore reveals large marketable gilt-supply news that is plausibly separated from fiscal-policy news. A shock that increases gilt issuance by one percent of GDP raises the 10-year government bond yield by about 9 basis points and widens the corporate bond risk spread by about 2 basis points. The results support a preferred-habitat view in which constrained arbitrageurs intermediate both government and corporate bond markets. Fiscal policy therefore transmits not only through standard demand and tax channels, but also through financial crowding out in debt markets.

Is deficit finance free when real borrowing rates are routinely lower than growth rates? We study this question in a production-based asset-pricing model that features heterogeneous trading technologies as well as idiosyncratic and aggregate risk and can match the observed low average risk-free rate and the high market price of risk. We use our model to examine under which conditions realistic calibrations allow for (bounded) intertemporal arbitrage, that is to say, the possibility of infinite rollover of a short position. We give examples where this infinite rollover is possible. However, for our benchmark calibration that matches the high market price of risk observed in the data, rollover is impossible even if the average risk-free rate lies 3.5 percent below the average growth rate. The result is robust with respect to the introduction of permanent growth shocks.

We study the equilibrium effects of financial repression on government funding costs in an endowment economy with limited asset market participation. We show how a broad set of repression policies operates through a wedge in the Euler equation responsive to government size or by affecting fiscal redistribution between agents. Repression intensity is captured by a policy feedback rule that depends positively on net government spending. When fiscal policy is profligate and monetary policy accommodates, we show that such a repression policy raises bond values, reduces the inflationary cost of unfunded fiscal expansions, and lowers bond risk premia. Repression is not a free lunch for bondholders-they pay a lower inflation tax but also earn lower future real returns. When monetary policy does not accommodate fiscal policy, repression can provide stopgap funding for deficits, allowing the central bank to retain control over inflation while making government debt a hedge for fiscal inflation.