Deficit Aversion as a Path to Higher Debt: Sovereign Debt Dynamics in a Stock-Flow Consistent Model with Public Capital

Abstract

I develop a stock-flow consistent model that incorporates public sector into economy and offers a novel framework to evaluate the long-term economic consequences of government budgetary decisions. In this model, both government consumption and investment enter the aggregate income; however, public investment adds up to the public capital stock. The productivity of the private capital depends on the public capital stock due to congestion effects. The composition of public spending, however, depends on fiscal rules. I simulate two scenarios: a balanced budget fiscal rule and a ‘golden rule of public investment’. The investment-friendly fiscal rule requires public deficits, but it induces a higher growth rate, a higher capacity utilisation, and, eventually, a lower debt-to-output ratio than the balanced budget rule. I conclude that a policy that boosts productivity is more effective for fiscal sustainability than focusing on reducing the public deficit.