Working Paper 2016-11: J.W. Mason & Arjun Jayadev
J.W. Mason, Assistant Professor of Economics, John Jay College, City University of New York
Arjun Jayadev, Associate Professor of Economics and Graduate Program Director, University of Massachusetts, Boston
The interest rate and the fiscal balance can be thought of as two independent instruments to be assigned to two targets, the path of output and the path of public debt. Under what we term a ’sound finance rule’ the interest rate targets output while the fiscal balance targets public debt; under a ‘functional finance rule’ the budget balance is assigned to the output gap and the interest rate to the debt ratio. The same unique combination of interest rate and fiscal balance will be consistent with output at potential and a constant debt-GDP ratio regardless of which instrument is assigned to which target The stability characteristics of the two rules differ, however. At low levels of debt, both rules converge, but at high levels of debt, only the functional finance rule converges. So contrary to conventional wisdom, the case for countercyclical fiscal policy becomes stronger, not weaker, when the ratio of public debt to GDP is already high. We apply our framework to describe policy generated cycles in the US over the past five decades.