Central Bank of Latvia working paper examines how macroeconomic and fiscal shocks affect euro area public debt trajectories

The Central Bank of Latvia published a working paper assessing how macroeconomic shocks and budget balance shocks shape public debt paths across the euro area, using country-specific structural vector autoregression models and panel local projection methods to estimate impulse responses. The analysis finds that a positive GDP shock produces a persistent decline in the debt-to-GDP ratio, while a positive GDP deflator shock lowers the debt ratio only temporarily. By contrast, a positive interest rate shock leads to a substantial and lasting increase in the debt ratio. A positive primary balance shock, interpreted as discretionary austerity, reduces the debt ratio significantly but with an estimated lag of around one year. The paper also reports state-dependent and non-linear effects: austerity is more effective after periods of economic expansion than after recessions and when initial public debt is low rather than high; GDP shocks reduce the debt stock more when the debt stock is initially large; and the debt response to a positive budget balance shock is more persistent and statistically significant when the shock is large.