Non-Linear Fiscal Regimes and Interest Rate Policy

Much empirical evidence finds that governments react to fiscal imbalances in a non-linear way, through an increasing marginal response of primary surpluses to changes in debt. This paper shows that non-linear fiscal regimes alter equilibria under active and passive monetary-fiscal policies. The Fisher equation combined with non-linear fiscal policies leads to multiple steady states. Under passive interest rate rules, even if the steady state at which fiscal policy is active is locally saddle-path stable, there exist infinite equilibrium paths originating in the neighborhood of that steady state which converge into a high-debt trap. Under active interest rate rules, even if the steady state at which fiscal policy is active is locally unstable, there exists a saddle connection with the high debt equilibrium along which inflation is uniquely determined.