Throwing Darts and Missing the Bullseye: Fiscal and Debt Sustainability in Open Economies

Author(s): Central Bank Of Barbados

Created 14 Apr, 2023
Categories Working Papers
Views: 554

The standard debt sustainability condition emerges from the government’s intertemporal budget constraint and omits goods market (flow) equilibrium. Consequently, the debt-targeting fiscal rule of a long-run primary surplus overshoots/undershoots the steady-state debt ratio. In other words, the standard debt sustainability analysis is not stock-flow consistent, which is necessary for appropriate analysis as debt ratios combine stock (debt) and flow (GDP or exports) variables. This research shows that the price of stock-flow inconsistency is significant volatility: debt or foreign exchange crises. This article formalizes a stock-flow consistent model of fiscal and debt sustainability in an open economy. It demonstrates that a primary deficit as a share of GDP obtains goods market equilibrium at potential output and a steady-state debt ratio, irrespective of the exchange rate regime and even when the economy is dynamically efficient. The model derives a simple rule that specifies the precise primary deficit required for stock-flow equilibria.

JEL Classification: E32, E62, F31, F41, H62, H63
Keywords: Debt Sustainability, Primary Deficit, Stock-Flow Equilibria, Open Economy

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