DP15950 The constraint on public debt when r < g but g < m

Author(s): Ricardo Reis
Publication Date: March 2021
Keyword(s): debt limits, debt sustainability, incomplete markets, Misallocation
JEL(s): D52, E62, G10, H63
Programme Areas: Financial Economics, Monetary Economics and Fluctuations, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15950

With real interest rates below the growth rate of the economy, but the marginal product of capital above it, the public debt can be lower than the present value of primary surpluses because of a bubble premia on the debt. The government can run a deficit forever. In a model that endogenizes the bubble premium as arising from the safety and liquidity of public debt, more government spending requires a larger bubble premium, but because people want to hold less debt, there is an upper limit on spending. Inflation reduces the fiscal space, financial repression increases it, and redistribution of wealth or income taxation have an unconventional effect on fiscal capacity through the bubble premium.