Explaining Movements in Government Debt

Standard New Keynesian models with time-consistent policy predict minimal debt responses to conventional shocks, as a debt stabilization bias dominates tax-smoothing motives.

Standard New Keynesian models with time-consistent policy predict minimal debt responses to conventional shocks, as a debt stabilization bias dominates tax-smoothing motives. We show that two mechanisms can generate debt movements of the magnitude observed in the data: increases in policymaker myopia and declines in real interest rates, such as during flight-to-safety episodes. Other potential drivers—changes in markups, debt maturity, government transfers, or large recessions—cannot account for such fluctuations.