Fiscal Sustainability and Excessive Public Debt

Filipe António Bonito Vieira

Student thesis: Master thesis


This thesis uses a 2-period overlapping generations model with public debt to derive fiscal sustainability conditions and optimal fiscal policies for countries with an excessive debt stock or threatened by such a possibility. The OLG model is built on the assumption that there are no bequest motives, where public debt is the main intertemporal variable effectively connecting different generations of people. This framework enables the capture of intertemporal aspects of fiscal policy in relation to the savings-investment transmission mechanism. The model also nests an endogenous interest rate, which limits possible steady-state equilibria by the dynamic efficiency of the economy. The development of sustainability criteria is based on a fiscal rule of maintaining the debt level constant, which enables the derivation of optimal fiscal policy in order for a government to sustain in given debt levels in steady-state equilibrium. In turn, optimal fiscal adjustments are derived with a fiscal rule of maintaining a constant primary deficit ratio. Here, two types of fiscal adjustment processes are analyzed, termed horizontal and vertical adjustments. A horizontal adjustment comprises a specific schedule of tax rate and expenditure ratio for a government wishing to reduce the debt-GDP ratio to a chosen target within a given time-frame. Vertical adjustments comprise optimal fiscal responses in case a government suffers an exogenous expenditure shock. In this case, having one available fiscal tool, a tax rate schedule is derived as the optimal response for temporary and permanent expenditure shocks. In case a government is unable to establish the optimal tax rate response, an optimal debt default operation is derived for given expenditure shock intensities.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
Publication date2015
Number of pages89