A Goldilocks Theory of Fiscal Deficits

Mian, Atif; Straub, Ludwig; Sufi, Amir

doi:10.1257/aer.20220308

Abstract

This paper proposes a tractable framework to analyze fiscal space and the dynamics of government debt, with a possibly binding zero lower bound (ZLB) constraint. Without the ZLB, a greater primary deficit unambiguously raises debt. However, debt need not explode: When R < G 鈭� 蠁, where 蠁 is the sensitivity of R 鈭� G to debt, a modest permanent increase in the deficit can be sustained forever鈥攁鈥渇ree lunch鈥� policy. With the ZLB, the relationship between deficit and debt can become non-monotone. Both high and low deficits can increase debt, as the latter weaken demand and reduce nominal growth at the ZLB.

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