Government Debt and Economic Growth in an Overlapping Generations Model

Abstract

Prior studies have shown that an increase in government debt raises the real interest rate and lowers the rate of economic growth. In an overlapping generations model of endogenous growth, this paper shows that an increase in government debt may not increase the real interest rate with the real interest rate being greater than the growth and that an introduction of government debt will increase the growth rate of per capita output if the growth rate is greater than the real interest rate and will decrease the growth rate if the growth rate is less than the real interest rate. Recent decades have seen a large increase in the share of government debt in national income in many countries. This paper develops an endogenous growth model of overlapping generations to examine the effect of government debt on the rate of economic growth.' Most prior studies of the effects of government policies on economic growth have assumed that government debt is absent. Romer (1986), Jones and Manuelli (1990), King and Rebelo (1990), and Rebelo (1991) showed that when government spending is not productive, an increase in the income tax rate will lower the rate of per capita output growth.2 Barro (1990) showed that an increase in government spending may either increase or decrease the rate of growth in a model with productive government spending. Government debt was incorporated in endogenous growth models by King (1992) and van der Ploeg and Alogoskoufis (1994). King (1992) developed a model of endogenous growth and showed that a necessary condition for the feasibility of perpetual debt finance is that labor's share of income must be greater than two-thirds. Van der Ploeg and Alogoskoufis (1994) developed a Blanchard-type overlapping generations (OG) model of endogenous growth and found that an increase in government debt, arising from an intertemporal shift in taxation, reduces the growth rate. This paper analyzes the effect of government debt by developing a Diamond-type of OG