Policy Orientation and Analysis of China’s Fiscal Deficits

【Authors】

ZHU Zixiang, YANG Zhongzhen,LI Rong & JIA Pengfei

【WorkUnit】

ZHU Zixiang, YANG Zhongzhen (Sichuan University, 610065)；LI Rong (Renmin University of China, 100872)；JIA Pengfei (Nanjing University, 210093)

【Abstract】

Amid China’s proactive fiscal policy aimed at stimulating domestic demand and mitigating external uncertainties, this study addresses a notable macroeconomic puzzle: the sustained coexistence of persistent fiscal deficits, rising government debt, and low inflation—a phenomenon not adequately explained by standard New Keynesian or Fiscal Theory of the Price Level (FTPL) frameworks. China’s ongoing structural shift toward a service-based economy, characterized by significant sectoral heterogeneity in price rigidity, has further reshaped fiscal policy transmission in ways that remain underexplored. This paper seeks to disentangle the macroeconomic effects of fiscal deficits, identify the prevailing fiscal-monetary policy mix, and quantify how this structural transformation influences fiscal policy effectiveness.
We develop a two-sector New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model grounded in the FTPL, incorporating three key innovations. First, we introduce a continuous parameter to capture the full spectrum of policy regimes between monetary and fiscal dominance, reflecting the nuanced and mixed nature of China’s policy framework. Second, we incorporate heterogeneous price rigidity between the services and goods sectors to examine how servitization alters fiscal transmission via the price rigidity channel. Third, we include both optimizing and rule-of-thumb households to break Ricardian equivalence, providing a more realistic micro-foundation for aggregate demand effects. A “shadow” fiscal-dominant economy is constructed to model the partially unfunded component of government debt.
Estimated with Bayesian methods using Chinese quarterly data from 1997Q1 to 2023Q4, the model yields three main findings. First, it resolves the “fiscal paradox” by showing that a monetary dominant regime, which limits deficit monetization and fiscal inflation, combined with rising price rigidity from servitization (which flattens the Phillips curve), explains why sustained fiscal expansion has not fueled high inflation. Second, the effects of fiscal policy are regime-dependent: under a fiscal dominant regime, government spending and tax multipliers rise substantially, and expansion can reduce the debt-to-GDP ratio via growth and inflation dilution; under monetary dominance, fiscal stimulus has weaker effects and raises debt burdens. Third, servitization amplifies the output effects of fiscal stimulus while dampening its inflationary impact under monetary dominance, with the opposite holding under fiscal dominance. Welfare analysis further reveals that while a fiscal-dominant regime can alleviate debt pressure, it incurs greater welfare losses from inflation distortions—losses that can be mitigated by a more advanced service-oriented economic structure.
Our findings offer three policy implications. First, short-term stimulus and long-term debt sustainability are compatible under a coordinated fiscal-monetary regime that tolerates mild fiscal inflation. Second, a growth-driven strategy for debt reduction is more suitable for China than inflation-driven erosion, given the ongoing servitization and structurally higher price rigidity. Third, policymakers must guard against risks from a reversal of the interest rate-growth differential and from digital transformation, which could reduce price rigidity and amplify inflationary effects.

JEL: E62, E31, E63

【KeyWords】

Fiscal Deficit, Fiscal Theory of the Price Level, Growth-Driven Debt Resolution, Moderate Inflation