Low Interest Rates, Growth, and Sustainable Fiscal Policies

Abstract:

This paper establishes a growth theory that enable us to study fiscal policies in economies of low interest rates on debt. In order to explain low interest rates, we introduce financial frictions, namely, uninsurable idiosyncratic risk in capital income and borrowing constraints faced by firms, into a standard endogenous growth model. Interest rates on debt can fall below the economic growth rate, and then the government can sustain debt by running primary deficits. Low interest rates on debt arise from the shortage in liquidity, and thus those low rates are associated with low investment and slow economic growth. The choice faced by the government is either the set of deficits and slow growth or the set of surpluses and fast growth. We show that the current Japanese economy falls into a region of liquidity shortage. We evaluate fiscal policies at aiming fiscal surpluses above zero from the perspective of
our model.