Optimal correction of the public debt and measures of fiscal soundness

Abstract

This paper derives the optimal response of the primary budget balance to changes in the public debt as a share of gross domestic product (GDP) in a stochastic model of debt. Under the optimal solution, the surplus reactivity to the debt-GDP ratio is independent of the debt ratio itself, but its size depends on the degree of uncertainty surrounding the impact of fiscal policies. We characterize the properties of the optimal control policy by proposing different metrics that may be used to assess fiscal soundness and as early warning indicators of fiscal imbalances.