Debt and the Effects of Fiscal Policy ∗
Carlo Favero and Francesco Giavazzi †
February 20, 2008
Equilibrium structural models of fiscal policy are solved by impos-
ing the government intertemporal budget constraint and are simulated
under the equilibrium assumption that the real value of the debt in
the hands of the public must equal the expected present value of gov-
ernment surpluses. Empirical models of fiscal policy typically do not
impose this condition and usually do not even include debt. This is
particularly surprising in the case of countries where the data reveal
that fiscal variables respond to the level of the debt. In this paper
we conduct VAR analysis of US fiscal policy by explicitly including
debt and the stock-flow identity linking debt and deficits. We apply
our methodology to different identification approaches: the structural
VAR approach and the narrative approach. Our main findings are that
the absence of an effect of fiscal shocks on long-term interest rates–a
frequent and puzzling result in research based on VARs that omit a
debt level–can be explained by their mis-specification, especially over
samples in which the debt to GDP ratio is very high by its historical
standards. The explicit inclusion of the debt-deficit dynamics does not
alter sizeably the effect of fiscal policy on output in standard struc-
tural VARs, more sizeable differences are obtained when the narrative
approach is considered.
Keywords: fiscal policy, public debt, government budget con-
straint, VAR models
JEL Classification: H60, E62
∗We thank Olivier Blanchard, Eric Leeper and Roberto Perotti for useful comments.
Francesco Giavazzi thanks the Federal Reserve Bank of Boston for its hospitality while
this paper was completed.
†Favero: IGIER (Universita’ Bocconi) and CEPR. Giavazzi, IGIER (Università Boc-
coni), MIT, CEPR and NBER.
Empirical, VAR based, evidence on the effects of fiscal policy is designed to
serve the purpose of selecting the appropriate structural model to conduct