IEAS Working Paper No. 23-A007, December 2023

Abstract:
Large expansionary fiscal measures are often implemented with monetary accommodation during an economic crisis.  When a government is highly indebted, and the timing of switching to the conventional regime M (passive fiscal/active monetary policies) is uncertain, a government spending increase in regime F (active fiscal/passive monetary policies) increases government debt.  Such regime uncertainty dampens inflation and debt revaluation effects.  Also, as regime uncertainty generates a smaller real interest rate decline, debt servicing costs fall less, and tax revenues increase less, than in the fixed regime F.  These factors contribute to reversing the debt decline for a spending increase in the fixed regime F.  The result holds under adverse supply shocks and potentially higher capital taxes, relevant factors in the post-COVID U.S. economy.