Huixin Bi, Ms. Wenyi Shen, and Susan Yang Shu-Chun
This paper studies the main channels through which interest rate normalization has fiscal implications in the United States. While unexpected inflation reduces the real value of government liabilities, a rising policy rate increases government financing needs because of higher interest payments and lower real bond prices. After an initial decline, the real government debt burden rises even with higher tax revenues in an expansion. Given the current net debt-to-GDP ratio at around 80 percent, interest rate normalization leads to a negligible increase in the sovereign default risk of the U.S. federal government, despite a much higher federal debt-to-GDP ratio than the post-war historical average.
After a period of adjustment to the fiscal shock, real interest rates return to their baseline level, because New Zealand is too small to move world interest rates. Output remains below baseline for an extended period and settles at 0.75 percent above baseline in the long run. However, weak domestic demand and a depreciated REER boost the trade balance. Net foreign liabilitiesdecline and over time the change in the income balance drives the current account improvement.
b) A very large decline in the risk premium could lead to a widening current-account deficit. A