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Public Debt Overhang in the Heterogeneous Agent Model

Keiichiro Kobayashi

Discussion papers from Research Institute of Economy, Trade and Industry (RIETI)

Abstract: In this paper, I demonstrate that expansionary fiscal policy associated with an increase in public debt can cause a persistent recession. I assume that entrepreneurs have borrowing constraints and that the government issues debt and collects tax from productive entrepreneurs. The government can also transfer resources to workers. Under this setting, an increase in public debt per se can enhance economic growth as it can compensate for the shortage of liquidity. However, output decreases as the transfer increases due to the income effect of the transfer on workers increasing the wage rate. Noticeably, both output and interest rates decline as the transfer and debt become larger. This result challenges the widely accepted view that the negative effect of expansionary fiscal policy on output should be the crowding-out effect that works through a hike in interest rates. It also implies that redistribution from workers to productive agents may enhance economic growth.

Pages: 21 pages
Date: 2014-07
New Economics Papers: this item is included in nep-dge and nep-pbe
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Persistent link: https://EconPapers.repec.org/RePEc:eti:dpaper:14044

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