Policy Mix and Debt Sustainability: Evidence from Fiscal Policy Rules

Abstract

This paper characterizes rules-based fiscal policy setting for G-3 and large EMS countries. We set up a simple fiscal policy rule and then infer on the policymakers’ reaction coefficients by testing with GMM. Our results qualify existing evidence on systematic fiscal policy in two respects. First, fiscal policy usually stabilizes public debt; and there is indeed substantial interaction between fiscal and monetary policies via the policy mix or the debt channel. Second, sustainability is achieved with a ‘‘stop–go’’ cycle of consolidation. Unless debt ratios are high, consolidation does not come at the cost of less cyclical stabilization