A Buffer-Stock Model for the Government: Balancing Stability and Sustainability

IMF Working Papers, July 22, 2019

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A fiscal reaction function to debt and the cycle is built on a buffer-stock model for the government.
The model is inspired by the buffer-stock model of the consumer (Deaton 1991; Carroll 1997).
The model includes a debt limit instead of the Intertemporal Budget Constraint (IBC).
The IBC is weak (Bohn, 2007); a debt limit is more realistic as it reflects the risk of losing market access.
This risk increases the welfare cost of fiscal stimulus at high debt.

The higher the debt, the less governments should smooth the cycle.
A larger reaction of interest rates to debt magnifies the interaction between the debt level and the appropriate reaction to shocks.
Higher hysteresis magnifies the interaction between the debt level and the appropriate reaction to shocks.
With very persistent shocks, the appropriate reaction to negative shocks in highly indebted countries can even be procyclical.

Recognize a debt limit (market-access risk) as a binding constraint that alters optimal fiscal stabilization behavior relative to models assuming a strong IBC.
Scale fiscal stimulus considerations by current debt levels: at higher debt, weigh welfare costs of stimulus more heavily.
Account for the sensitivity of interest rates to debt when designing fiscal reaction functions.
Consider hysteresis effects and shock persistence when deciding between cyclical smoothing and fiscal consolidation; persistent negative shocks in high-debt settings may warrant procyclical responses.