The Interplay of Interest Rates and Debt-Financed Government Spending

Persistently low interest rates on government debt over past decades have prompted some economists to question the wisdom of fiscal policies that restrict the use of deficits to finance government spending. In the new EconPol Policy Brief Bev Dahlby and Ergete Ferede argue that the widely held view that there is no, or only a low, fiscal cost from debt-financed increases in program spending can be misleading. Higher public sector debt levels can lead to higher real interest rates and lower economic growth rates, forcing the government to run a smaller primary deficit to stabilize the debt ratio. This will push up the average fiscal cost of program spending, defined as the ratio of taxes to program spending. Marginal fiscal cost, i.e., the additional taxes imposed to stabilize the debt ratio, can exceed the increase in deficit-financed spending.