Fiscal Expansions in the Era of Low Real Interest Rates
When the natural real interest rate is low, the power of monetary policy to revive the economy is limited due to the zero lower bound on the nominal interest rate. In most models, increasing government debt raises the natural real interest rate, which in turn restores the power of monetary policy to stimulate the economy. However, this paper shows that even in a low real interest rate environment, higher debt doesn’t necessarily raise the natural real interest rate, not if the current period of low real interest rates is expected to be short-lived.
The author notes that if the government accumulates substantial debt and the low real interest rate period is brief, it will have to finance this debt at positive real interest rates when the rates normalize. This financing will impose costs on the economy by triggering distortionary taxes or other forces that reduce output. The anticipation of these costs may induce further savings today and reduce the positive effect of the debt. If these costs are severe enough, the precautionary savings generated by the debt could be so large that the natural real interest rate falls.
In formalizing this argument, the author shows that the effect of increasing debt depends on the probability of reverting from a low real interest rate state to a business-as-usual state—one in which the real interest rate rise. If the probability of reversion is low, increasing debt will raise the natural real interest rate; but if the probability is high, increasing debt will lower the rate. Also, when the initial debt-to-GDP ratio is low, increasing debt raises the natural real interest rate; but it decreases the rate when the ratio is high. The threshold level of the debt-to-GDP ratio—the point at which the effect of increasing debt becomes perverse—is a function of the probability of reverting from a low real interest rate state to a business-as-usual state.