Analyzing Macroeconomic Effects of Government Debt Using Dynamic General Equilibrium Model

Abstract

This paper uses a dynamic general equilibrium model with government sector and analyzes short-run and long-run macroeconomic effects of government debt caused by either increases in government spending or decreases in various tax rates. The simulation results suggest several channels that government debt can negatively affect the economy: First, liquidity premium caused by an increase in government debt increases interest rate and decreases investment, and therefore lowers output and welfare in the long run. This is the most significant negative channel in this model. Second, when government spending builds up public capital, an increase in government debt temporarily crowds out private sector capital, which reduces output and welfare in the short run. Third, when government spending affects neither public sector capital nor household utility, an increase in government debt reduces consumption and increases labor input, thereby reducing social welfare. In addition, if the increase in government debt is caused by a decrease in tax rates, positive effects can dominate.