A Goldilocks Theory of Fiscal Deficits
063022-WP-A Goldilocks Theory of Fiscal Deﬁcits-Mian Straub and Sufi
Atif Mian, Princeton University
Ludwig Straub, Harvard University
Amir Suﬁ, University of Chicago
This paper proposes a tractable framework to analyze fiscal space and the dynamics of government debt, with a possibly binding zero lower bound (ZLB) constraint. Without the ZLB, a greater primary deficit unambiguously raises debt. However, debt need not explode: When R < G –ϕ, where ϕ is the sensitivity of R – G to debt, a modest permanent increase in the deficit can be sustained forever—a “free lunch” policy. With the ZLB, the relationship between deficit and debt can become non-monotone. Both high and low deficits can increase debt, as the latter weaken demand and reduce nominal growth at the ZLB. A rise in income inequality expands fiscal space outside the ZLB, but contracts it at the ZLB. Calibrating the model, we find little space for “free lunch” policies for the United States in 2019, but ample space for Japan.