The Fiscal Cost of Public Debt and Government Spending Shocks

Abstract: This paper investigates how the cost of public debt shapes fiscal policy and its effect on the economy. Using U.S. historical data, I show that when servicing the debt creates a fiscal burden, the government responds to spending shocks by limiting debt issuance. As a result, the initial shock triggers only a limited increase in public spending in the short run, and even leads to spending reversal in the long run. Under these conditions, fiscal policy loses its ability to stimulate economic activity. This outcome arises as the fiscal authority limits its own ability to borrow to ensure public debt sustainability. These findings are robust to several identification and estimation strategies.