Public Debt Dynamics Over the Business Cycle: A Fresh Perspective

ABSTRACT Understanding the cyclical nature of the public debt‐to‐GDP ratio is essential for policy decision‐making. This article proposes a theoretical framework to explain the dynamics of the public debt‐to‐GDP ratio over the business cycle by categorising them into three phases. There is a bounded interval within which the public debt‐to‐GDP ratio is in the counter‐cyclical phase, increasing in booms and decreasing in recessions. The debt‐to‐GDP ratio is in the accumulation phase when it is below the interval and in the reduction phase when it is above the interval. Importantly, the accumulation or reduction phase is expected to be followed by the counter‐cyclical phase. The bounded interval is not static, implying the significant recurrence of the counter‐cyclical phase and the time‐varying cyclical properties of the debt‐to‐GDP ratio. This study further proposes an iteration scheme to estimate the interval. Empirical results from five developed and five developing countries indicate that the patterns of the three phases differ across countries but exhibit similar trends within each country group. External factors such as income risks and austerity can change the bounds of the interval, thereby shifting the public debt dynamics to the accumulation or reduction from the counter‐cyclical phase.