The effect of government spending on the debt-to-GDP ratio in the medium term

Abstract

Using the dynamic model proposed by Leão and Leão (2024), this paper argues that, in an economy situated below full employment, an increase in government spending may reduce the debt-to-GDP ratio in the medium term. The reason is the following one. Through the so-called “paradox of investment”, a fiscal stimulus triggers a multi-year process of mutually fed increases in the rate of utilization of productive capacity and in private investment. Specifically, a fiscal stimulus increases output and utilization, and this leads firms to raise investment. But this increase in investment generates less productive capacity than demand and, therefore, provokes a paradoxical and further rise in utilization. This in turn leads to even more investment, and so on—the result being a sustained path of output growth. This will in turn have an impact on public finances. After having deteriorated initially as a result of the fiscal stimulus, the budget balance and the path of public debt will start to improve, and this, coupled with the sustained output growth, may end up reducing the debt-to-GDP ratio in the medium term. The theoretical argument just presented is then used to elucidate the results of the US New Deal of the 1930 s, of the European fiscal consolidation of the early 2010 s, and of the US fiscal stimulus of 2009–2010.