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Traders work on the floor of the New York Stock Exchange (NYSE) shortly after the announcement that the U.S. Federal Reserve had hiked interest rates for the first time in nearly a decade in New York, December 16, 2015. The U.S. central bank's policy-setting committee raised the range of its benchmark interest rate by a quarter of a percentage point to between 0.25 percent and 0.50 percent, ending a lengthy debate about whether the economy was strong enough to withstand higher borrowing costs. REUTERS/Lucas Jackson      TPX IMAGES OF THE DAY      - RTX1Z04O

Debt sustainability in a low interest rate world

Editor's Note:

This working paper was prepared for "The fiscal-monetary mix in an era of low interest rates," a June 2 event presented by the Hutchins Center on Fiscal and Monetary Policy at Brookings.

Neil R. Mehrotra

Assistant Vice President and Policy Advisor - Federal Reserve Bank of Minneapolis

Conditions of secular stagnation – low growth and low real interest rates – have counteracting effects on the cost of servicing the public debt. With sufficiently low interest rates relative to growth, governments can raise revenues by increasing the debt to GDP ratio. Mehrotra analyzes empirically and theoretically the tradeoffs involved with increased public debt. Using data from 1870 for advanced economies, interest rates on government debt are frequently less than GDP growth. However, despite current conditions of r < g, he finds a moderate probability of reversion to conditions with r > g over a 5 or 10 year horizon and substantial variability in r − g. Using a 56 period quantitative lifecycle model calibrated to the US, the author shows that slower population growth worsens the cost of servicing the debt, while slower productivity growth improves this cost. Despite r < g, the level of public debt that minimizes the cost of servicing the debt is lower than current levels.

The Washington Center for Equitable Growth has provided Neil Mehrotra with financial support for his research, but did not provide support for this paper. The author did not receive additional financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. They are currently not an officer, director, or board member of any organization with an interest in this article.

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