The impact of government debt on the long-run natural real interest rate – a quantitative evaluation

Christoph Winter

Applied Economics Letters, 2017, vol. 24, issue 20, 1429-1434

Abstract: Persistently low natural real interest rates are a problem for monetary policy and financial stability. I analyse to what extent a permanent increase in government debt that is financed by higher taxes could raise the long-run natural real interest rate. As a measurement tool, I use an incomplete markets model with capital and government bonds. Increasing the public debt/GDP ratio by one percentage point raises the real interest rate by between 0.4 and 1.5 basis points, depending on the degree of inequality generated by the model and the tax instrument used to balance the government’s budget constraint. I also show that the interest rate effect of a change in public debt/GDP predicted by the model is significantly smaller than its empirical counterpart for the US, due to the fact that the model understates the empirical fraction of households that are constrained in their consumption decision.

Date: 2017
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DOI: 10.1080/13504851.2017.1282137

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