Investment Cycles and Sovereign Debt Overhang

44 Pages Posted: 27 Aug 2007 Last revised: 28 Jun 2010

See all articles by Mark Aguiar

Mark Aguiar

Princeton University

Manuel Amador

affiliation not provided to SSRN

Gita Gopinath

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: August 2007

Abstract

We characterize optimal taxation of foreign capital and optimal sovereign debt policy in a small open economy where the government cannot commit to policy and seeks to insure a risk averse domestic constituency. The expected tax on capital is shown to vary with the state of the economy, generating cyclicality in investment and debt in an environment where the first best capital stock is a constant. The government's lack of commitment induces a negative correlation between investment and the stock of government debt, a "debt overhang'' effect. If the government discounts the future at a rate higher than the market, then capital oscillates indefinitely at a level strictly below the first best. Debt relief is never Pareto improving and cannot affect the long-run level of investment. Further, restricting the government to a balanced budget can eliminate the cyclical distortion of investment.

Suggested Citation

Aguiar, Mark and Amador, Manuel and Gopinath, Gita, Investment Cycles and Sovereign Debt Overhang (August 2007). NBER Working Paper No. w13353, Available at SSRN: https://ssrn.com/abstract=1009803

Mark Aguiar

Princeton University ( email )

Princeton, NJ 08544-1021
United States

Manuel Amador

affiliation not provided to SSRN

Gita Gopinath (Contact Author)

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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