The Fiscal Cost of Public Debt and Government Spending Shocks

TL;DR

This paper examines how the cost of public debt influences fiscal policy responses to spending shocks, showing that high debt costs constrain government spending increases and reduce fiscal policy effectiveness.

Contribution

It demonstrates that debt servicing costs lead governments to limit borrowing and spending responses, affecting fiscal policy's ability to stimulate the economy.

Findings

Limited short-term increase in public spending after shocks

Long-term spending reversal occurs when debt costs are high

Fiscal policy effectiveness diminishes with rising debt costs

Abstract

This paper investigates how the cost of public debt shapes fiscal policy and its effect on the economy. Using U.S. historical data, I show that when servicing the debt creates a fiscal burden, the government responds to spending shocks by limiting debt issuance. As a result, the initial shock triggers only a limited increase in public spending in the short run, and even leads to spending reversal in the long run. Under these conditions, fiscal policy loses its ability to stimulate economic activity. This outcome arises as the fiscal authority limits its own ability to borrow to ensure public debt sustainability. These findings are robust to several identification and estimation strategies.