Debt Reduction and Automatic Stabilization

47 Pages Posted: 31 May 2003

See all articles by Paul Hiebert

Paul Hiebert

European Central Bank (ECB)

Javier J. Pérez

Banco de España - Research Department

Massimo Rostagno

European Central Bank (ECB)

Date Written: October 2002


This paper presents an optimal fiscal policy response to address the basic trade-off between the automatic stabilisation properties of budgets and the long run fiscal positions. The framework is an overlapping generations model a la Weil (1989), extended to account for stochastic endowments and borrowing constrained households. A benign government chooses over the optimal degree of responsiveness of net taxes to individual incomes, an optimal measure of long-run public debt, or both, in order to smooth households' consumption across states of nature. In the presence of a deficit constraint for the government, the results unambiguously point to the desire for lower debt levels than those currently prevailing in order to enable a more effective hedging of personal income uncertainty by means of more active fiscal stabilisers. Citizens in economies exhibiting more pronounced cycles will favour less automatic stabilisation combined with a more aggressive policy of debt reduction.

Keywords: Public debt, automatic stabilisation, borrowing constraints, consumption

JEL Classification: H31, H63, E63

Suggested Citation

Hiebert, Paul and Perez, Javier J. and Rostagno, Massimo, Debt Reduction and Automatic Stabilization (October 2002). Available at SSRN:

Paul Hiebert (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314

Javier J. Perez

Banco de España - Research Department ( email )

Alcala 50
28014 Madrid


Massimo Rostagno

European Central Bank (ECB) ( email )

Kaiserstrasse 29
Postfach 16 03 19
D-60311 Frankfurt am Main
+49 69 1344 7663 (Phone)
+49 69 1344 7604 (Fax)

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