When r-g exhibits variability
In this paper, Mehrotra and Sergeyev, argue that the combination of low growth and low real interest rates carry contradictory implications for debt sustainability. In particular, they find that data for advanced economies show that r − g exhibits substantial variability over the medium-term. For the US and most other advanced economies, the cost of servicing public debt r − g is negative but a sudden rise in interest rates relative to growth with a large stock of debt could quickly result in explosive debt dynamics. The authors provide a theoretical framework for assessing debt sustainability in an environment when, on average, r < g. They use a continuous-time general equilibrium endowment economy where debt-to-GDP ratio is stochastic. They show that:
- When debt servicing costs are negative, the debt-to-GDP ratio may be non-explosive in the sense of having a well-defined stationary distribution, but that may not satisfy the sustainability criteria;
- Slower trend growth improves debt sustainability, while higher output risk reduces the interest rates for most of the equilibrium levels of debt but also tightens the fiscal limit.
Debt Sustainability in a Low Interest Rate World
Authors: Neil R. Mehrotra, Dmitriy Sergeyev
From: Federal Reserve Bank of New York, Bocconi University
