Fiscal stimulus in a high-debt economy? A DSGE analysis

Abstract

Intended stimulus effects are attenuated if expansionary policies are conducted at the cost of debt rollover, high interest payments, and heavy taxes. This paper examines the stimulus effects of fiscal instruments, considering a country's initial debt level. Using a neoclassical model calibrated to Greece, I find that: [1] increasing public consumption (investment) [wages] generates short-lived (long-lasting) [no] stimulus effects; [2] a rise in the interest rate spread reduces public consumption (investment) multiplier by 0.77 (only 0.27); [3] implementation delays in public investment yield the benefit of lower debt-to-GDP ratios, partly offsetting the cost of delays; [4] a high degree of consumption complementarity produces sizable expansionary effects, but it yields a worse fiscal position; [5] faster tax adjustments to government debt result in larger government-spending multipliers. In sum, whether to conduct stimulus measures or not hinges on a country's debt position, tools used, the speed at which debt is retired, and policy purposes.