38 Pages Posted: 19 May 2010 Last revised: 22 May 2010
Date Written: May 1, 2010
Abstract. We examine when government debt crowds out investment for the U.S. economy using an estimated New Keynesian model with a detailed fiscal specification. The estimation accounts for the interaction between monetary and fiscal policies. Whether private investment is crowded in or out in the short term depends on the fiscal or monetary shock that triggers a debt expansion: higher debt can crowd in investment despite a higher real interest rate for a reduction in capital tax rates or an increase in productive government investment. Contrary to the conventional view of crowding out, no systematic relationship among debt, the real interest rate, and investment exists. This result offers an explanation as to why empirical studies that have focused on the reduced-form relationship between interest rates and debt are often inconclusive. At longer horizons, distortionary financing is important for the negative investment response to a debt expansion.
Keywords: Crowding Out, Distortionary Debt Financing, Fiscal and Monetary Policy Interactions, Bayesian Estimation
JEL Classification: C11, E63, H63
Suggested Citation: Suggested Citation