Working Paper

Fiscal Implications of Interest Rate Normalization in the United States


Abstract: This paper studies the fiscal implications of interest rate normalization from the zero lower bound (ZLB) in the United States. At the ZLB, the decline in tax revenues and the real bond price drives up government debt. During normalization, interest payments continue to rise higher than they would have had rates not reached the ZLB, potentially increasing government debt even as output and tax revenues recover. We find that against the yardstick of ability to pay, interest rate normalization is unlikely to pose an immediate threat to debt sustainability at the current net federal debt level of 90 to 100 percent of GDP. If the net federal debt reaches 150 percent of GDP, however, sovereign default risk can rise more quickly. We also find that a more active monetary policy better anchors inflation expectations and generates a faster recovery than a less active one, helping slow debt accumulation during normalization.

Keywords: Interest rate normalization; Monetary and fiscal policy interaction; Debt sustainability; Non-linear DSGE model; New Keynesian model;

JEL Classification: E43; E52; E62; E63; H30;

https://doi.org/10.18651/RWP2020-12

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Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 2020-10-02

Number: RWP 20-12