Monetary and fiscal policy in a nonlinear model of public debt

Abstract

In this paper we study the dynamic relationship between the public debt ratio and the real interest rate. Specifically, by means of a macroeconomic model of simultaneous difference equations – one for the debt ratio and the other for the real interest rate – we focus on the role of monetary policy, fiscal policy and risk premium in affecting the stability of the debt ratio and the existence of steady states, if any. We show that, in a dynamic framework, fiscal rules may not be enough to control the pattern of the debt ratio, and the adoption of a monetary policy, in the form of an interest rate rule, is necessary to control the pattern of the debt ratio for assuring its sustainability over time. Notably, the creation or disappearance of steady states, or periodic (stable) cycles, can generate scenarios of multistability. While we obtain clear evidence that an active monetary policy has a stabilizing effect on both the real interest rate and the debt ratio, we also find that, in some scenarios, fiscal policy is not sufficient to avoid explosive patterns of the debt ratio.