“Throwing Darts and Missing the Bullseye: Fiscal and Debt Sustainability in Open Economies”
Abstract: This article develops a stock-flow consistent (SFC) model to study fiscal and debt sustainability in an open economy since the standard debt indicator (debt-GDP ratio) combines stock and flow variables. The model demonstrates that the government’s budget constraint yields a fiscal rule that is not SFC: a long-run primary surplus overshoots/undershoots stock-flow equilibria (the bullseye) or engenders debt crises. On the contrary, an SFC fiscal rule shows that a long-run primary deficit as a share of GDP obtains goods market equilibrium at potential output and a steady-state debt ratio, even when the economy is dynamically efficient and irrespective of the exchange rate regime. SFC accounting permits a primary deficit because it includes the private sector and external balances, unlike the government’s budget constraint. Moreover, the model finds that monetised-fiscal deficits undermine debt sustainability in fixed and flexible exchange rate systems by compromising the peg and increasing the rate of nominal depreciation, respectively.