Co-movement of Government Debt and Economic Growth in the Euro-area: A Bayesian Dynamic Factor Model Analysis

Abstract

This paper applies a Bayesian dynamic factor model to analyze the co-movement of government debt and economic growth in 12 euro-area countries from 1970–2009. We decompose the variations in output growth and government debt into three distinct factors: (i) a common factor capturing co-movement across the 24 series in all 12 countries; (ii) a country factor common to the two series in each country; and (iii) an idiosyncratic factor specific to each series. We find that the common factor affects output growth positively but government debt negatively. Furthermore, the common factor dominates the country and idiosyncratic factors in accounting for the fluctuations in output growth and government debt, especially in the period 1999–2009 when the common factor became less volatile but more important for macroeconomic fluctuations. Our results suggest some convergence in output growth and government debt in the 12 euro-area countries after the launch of the euro.