Government Debt, the Real Interest Rate and External Balance in an Endogenous Growth Model of a Small Open Economy

Abstract

This paper examines the effects of government debt policies with imperfect substitutability between securities issued by different countries. It puts forward an intertemporal model of a small open economy to analyze the effects of government debt on the real interest rate, economic growth, private consumption and the balance of payments. The model is an endogenous growth, overlapping generations model with convex adjustment costs for investment, and imperfect substitutability between domestic and foreign bonds. It is shown than an increase in the government debt to output ratio causes the spread between the domestic and the foreign real interest rate to rise and the endogenous growth rate to fall. In addition, when domestic government bonds are relatively close substitutes for foreign bonds, the rise in government debt causes a temporary rise in domestic consumption, as current generations view government debt as wealth. The current account moves into deficit, the economy decumulates net foreign assets, and in the new long run equilibrium both the consumption to output ratio and net foreign assets as a proportion of output fall. When domestic government bonds are not close substitutes for foreign bonds, the rise in government debt causes a temporary fall in domestic consumption, as the negative real interest rate effect of the rise in government debt dominates the wealth effect. In this case the current account improves and in the new long run equilibrium both the consumption to output ratio and net foreign assets as a proportion of output rise.