Does Government Debt Affect Multiplier Effect of Fiscal Expenditure? A Cross-country Analysis

Abstract

Is it in line with the typical facts of developed economies? Can government debt significantly affect multiplier effect of fiscal expenditure in other types of economies? If so, how to assess the moderate level of government debt? To answer these questions, this paper firstly constructs a local equilibrium model to theoretically analyze the effects of government debt on fiscal expenditure multiplier. Secondly, this paper uses LSDV model and panel data of 150 countries from 2000 to 2014, including developed countries, emerging markets and developing countries, to empirically analyze the effects of government debt on multiplier effect of fiscal expenditure. This paper also adopts military expenditure as a valid instrument variable to control endogeneity between fiscal expenditure and output by 2SLS. Finally, this paper assesses the moderate level of government debt by using PSTR model. It comes to the following conclusions: firstly, the empirical evidence is in line with theoretical expectations. With an increase in government debt, multiplier effect of fiscal expenditure tends to weaken. Secondly, there is a significant non-linear characteristic of government debt. When the proportion of government debt to GDP exceeds 88%, multiplier effect of fiscal expenditure reverses rapidly from positive to negative between low-debt and high-debt countries. Thirdly, the usage of pro-cyclical fiscal policy is very effective for the low-debt countries like China. As for the countries already at high debt level like the United States and Greece, it is necessary to take counter-cyclical fiscal policy so as to avoid the potential risk of economic fluctuations. The conclusion above is helpful for assessing the moderate level of China’s government debt and stabilizing government expectation of fiscal policy. Although China’s government debt is not high so far, the issue of hidden debt could not be underestimated. Therefore, China should thoroughly assess the government debt and control it within a moderate range, thus promoting the sustainability of its pro-cyclical fiscal policy.