Government Debt, The Real Interest Rate, Growth and External Balance in A Small Open Economy

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.

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Discussion Paper no. 9-13, Department of Economics, Athens University of Economics and Business

 

 

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Money, Growth and External Balance in a Small Open Economy

This paper puts forward an intertemporal model of a small open economy to analyze the effects of money, government debt and real shocks on growth, inflation and external balance. The model is an endogenous growth, overlapping generations model, with money in the utility function, convex adjustment costs for investment, and perfect substitutability between domestic and foreign bonds. It is shown that the growth rate depends only on the world real interest rate, the productivity of domestic capital, the adjustment cost parameter for investment and the depreciation rate. It does not depend on money, budgetary policies or the preferences of domestic consumers. Consumption of goods and services and external balance, in addition to the world real interest rate and the domestic productivity of capital, depend on money, budgetary policies and the preferences of domestic consumers. The model is used to analyze the full effects of real and monetary shocks. Monetary growth is not superneutral in this model, as it affects domestic consumption and the net foreign position of the economy.

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Working Paper 16-2012 Department of Economics AUEB

 

Endogenous Growth and External Balance in a Small Open Economy

This paper puts forward an intertemporal model of a small open economy which allows for the simultaneous analysis of the determination of endogenous growth and external balance. The model assumes infinitely lived, overlapping generations that maximize lifetime utility, and competitive firms that maximize their net present value in the presence of adjustment costs for investment. Domestic securities are assumed perfect substitutes for foreign securities and the economy is small in the sense of being a price taker in international goods and assets markets. The endogenous growth rate is determined solely as a function of the determinants of domestic investment, such as the world real interest rate, the technology of domestic production and adjustment costs for investment. The endogenous growth rate is independent of domestic savings and the preferences of consumers. Given the domestic growth and investment rate, the preferences of consumers determine the current account and external balance. The model can also be used to analyze the implications of budgetary policy. The world real interest rate affects growth negatively but has a positive impact on external balance. The productivity of domestic capital affects growth positively but causes a deterioration in external balance. Government consumption and government debt affect the current account and external balance negatively, but do not affect the endogenous growth rate. This model addresses and resolves the indeterminancy problems that arise in comparable representative household endogenous growth models of small open economies.

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Working Paper 15-2012 of Department of Economics AUEB