The impact of macroeconomic shocks on the government debt dynamics: How robust is the fiscal stance of the Czech Republic?

Abstract

This paper analyzes the effects of macroeconomic shocks on the government debt dynamics in an open economy using the analytical framework of Favero and Giavazzi (2007) extended to an open economy. Applying this modelling approach to the data for the Czech Republic, the authors derive some implications for fiscal policy. The modelling framework includes structural vector autoregression (SVAR) model, estimated using short-term identification restrictions, and non-linear specification of the government debt dynamics. The main variables of the analyzed system are GDP, inflation, the effective interest rate on government debt, government revenues and expenditures, the exchange rate and government debt. The estimation is carried out using the Bayesian approach. The results suggest that allowing for a non-linear dynamics in the government debt to GDP ratio could imply stronger persistence and higher volatility in the responses of government indebtedness to macroeconomic shocks. The fiscal stance of the Czech Republic seems to be most vulnerable to unexpected depreciation of the local currency, discretionary pro-cyclical increases in government expenditures, and deflationary shocks.