Fiscal financing components in a simple model of policy interaction

Abstract

Post-Great Recession many advanced nations have experienced an unprecedented rise in debt-to-GDP ratios. Among other factors, increasing age-related spending can add to fiscal stress with a high peacetime debt-GDP ratio. Therefore, it is crucial to understand the factors that can affect the debt dynamics. Previous literature highlights the components affecting the debt-GDP ratio as nominal interest rate, inflation, growth rate, and primary deficit/surplus. However, the contribution of these financing components was calculated without any reference to policy regimes. This paper calculates the financing components and their distribution under two regimes: “active” fiscal and “passive” monetary policy (“F”) and “active” monetary and “passive” fiscal policy (“M”) using US data between 1942 and 2017. The results show that inflation, growth rate, and primary deficit have played essential roles in affecting the debt-GDP dynamics under regime F.