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

_IMF Working Papers, July 22, 2019_

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## Bibliographic details
- Authors: Jean-Marc Fournier
- Published: July 22, 2019
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781498325066.001

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### Summary of the model and approach
- 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.

### Key findings and mechanisms
- 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.

### Policy implications and recommendations
- 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2019/07/22/a-buffer-stock-model-for-the-government-balancing-stability-and-sustainability-47074_