A Note On Nonlinear Fiscal Regimes And Interest Rate Policy

Much empirical evidence finds that governments react to fiscal imbalances in a nonlinear way, through an increasing marginal response of primary surpluses to changes in debt. This paper shows that nonlinear fiscal regimes alter equilibria under active and passive monetary–fiscal policies. The Fisher equation combined with nonlinear fiscal policies leads to multiple steady states. Under passive interest rate rules, even if the steady state in which fiscal policy is active is locally saddlepath stable, there exist infinite equilibrium paths originating in the neighborhood of that steady state that converge into a high-debt trap. Under active interest rate rules, even if the steady state at which fiscal policy is active is locally unstable, there exists a saddle connection with the high-debt equilibrium along which inflation is uniquely determined.