Fiscal Sustainability when Public Debt is High: The Role of Portfolio Liquidity
Working Paper Series no. 1055. This paper studies how the prevailing level of public debt shapes the transmission of fiscal and monetary policy shocks in a tractable heterogeneous three-agent New Keynesian model. When households rely on the liquidity services of government bonds to self-insure against idiosyncratic risk, higher public indebtedness amplifies the deterioration in debt sustainability after expansionary government spending shocks. In such economies, fiscal expansions weaken precautionary bond demand, requiring the central bank to keep real interest rates higher for longer and thereby raising debt servicing costs and narrowing fiscal space. By contrast, the transmission of monetary expansions is largely invariant to the initial debt level, as such shocks have little effect on the insurance value of government bonds. These results highlight the central role of the liquidity premium and self-insurance motive in linking initial public indebtedness to long-run fiscal sustainability.
Fiscal expansions are more costly for debt sustainability when public debt is initially high
Non-Technical Summary
Public debt in many advanced economies has increased substantially following recent crises. At the same time, higher interest rates have raised debt-servicing costs and renewed concerns about fiscal space. When debt is already high, governments may have less room to respond to future shocks or finance priority spending. Understanding how public indebtedness shapes the effects of fiscal and monetary policy is therefore important for assessing debt sustainability.
This paper studies how different initial levels of public debt affect the transmission of fiscal and monetary policy shocks. The analysis is based on a tractable New Keynesian model with three household types (capitalists, savers, and hand-to-mouth consumers) that differ in their access to financial assets and may move between types over time, reflecting idiosyncratic economic risk. In this environment, some households can save in assets with different liquidity profiles, notably liquid government bonds and illiquid capital. Government bonds are therefore valued not only for their return, but also because they help households self-insure against future changes in their economic circumstances.
The main finding is that fiscal expansions can pose greater risks to debt sustainability when public debt is initially high. For the same increase in government spending, real government debt rises more and remains elevated for longer when the economy starts from a higher debt-to-GDP ratio. The reason is that, at high debt levels, government bonds are already abundant liquid assets, so newly issued bonds provide a smaller additional insurance benefit to households. This weakens precautionary demand for bonds and lowers the liquidity premium – the expected return spread between illiquid capital and liquid government bonds which captures the value of bond liquidity. To induce households to absorb the additional public debt, real interest rates must remain higher for longer, raising debt-servicing costs and reducing fiscal space.
By contrast, the effects of monetary policy shocks are much less sensitive to the initial level of public debt. In the model, a monetary expansion lowers real interest rates, stimulates economic activity, and reduces debt-servicing costs. Because this shock has only a limited effect on the insurance value of government bonds, changing the initial debt-to-GDP ratio does not meaningfully alter its transmission. Overall, the results show that fiscal sustainability depends not only on debt levels and primary balances, but also on the liquidity value of government bonds and on households’ use of these bonds for self-insurance.
Keywords: Monetary–Fiscal Interactions, Heterogeneity, Liquidity, Self-Insurance, Government Debt, Debt Sustainability.
Codes JEL : E21, E52, E58, E62, E63.
Updated on the 23rd of July 2026