Flexible Debt Policy Rules in an Open Economy

Through a comparative dynamic analysis, we argue that the reality of public debt issuance, which responds flexibly to business cycles in contrast to the EU’s institutionally prescribed fiscal discipline, may contribute to macroeconomic stabilization. Through a simple econometric analysis, we find that the real operations of public debt management in European countries with excessive public debt are rather consistent with such flexible rules, even though the official EU fiscal discipline requires that the debt-to-GDP ratio be kept monotonically close to its long-run target. Using a small open economy model of endogenous growth, we demonstrate that the flexible debt policy rule serves to eliminate sunspot fluctuations due to equilibrium indeterminacy that occurs under official fiscal discipline. We also find that the flexible rule can lead to endogenous business cycles that depend only on economic fundamentals under equilibrium determinacy