Government Debt, Economic Activity, and Transmission of Economic Disturbances

Abstract

This paper analyzes the effects of government debt on output and the trade bala nce in a two-country rational expectations model of the world economy It is shown that perceived changes in government debt do not affect the level of economic activity but unperceived changes in the home country's government debt are correlated positively with its output and negatively with its trade balance. Unperceived increases in the foreign country's government debt, however, have a positive impact on the home country's output and the trade balance. Empirical evidence from the U.S. is consistent with most of the implications of the model. Copyright 1987 by Ohio State University Press.