By Jean-Marc Fournier
A fiscal reaction function to debt and the cycle is built on a buffer-stock model for the government. This model inspired by the buffer-stock model of the consumer (Deaton 1991; Carroll 1997) includes a debt limit instead of the Intertemporal Budget Constraint (IBC). The IBC is weak (Bohn, 2007), a debt limit is more realistic as it reflects the risk of losing market access. This risk increases the welfare cost of fiscal stimulus at high debt. As a result, the higher the debt, the less governments should smooth the cycle. A larger reaction of interest rates to debt and higher hysteresis magnify this interaction between the debt level and the appropriate reaction to shocks. With very persistent shocks, the appropriate reaction to negative shocks in highly indebted countries can even be procyclical.
Economists keep explaining that the government budget is not like the budget of a firm or a household. Here is a paper that tries to model a government like a household that follows a classic buffer-stock rule. This difference is that here the government loses access to market at a particular debt limit, and the distance to this limit is the buffer stock. Assuming this limit is known and invariant, this changes quite a bit the ability of the government to conduct fiscal policy.