The Burden of Public Debt in Neoclassical Growth Models: Do We Have to Worry About it?

Abstract

This paper investigates the crowding-out effect of public debt and the related loss in the long-run output in the framework of neoclassical growth models. To accomplish this task, we incorporate the government sector into three basic neoclassical models, which differ only in their assumptions about the consumption behavior of households. First, we consider the crowding-out effect of public debt in the Ramsey-Cass-Koopmans (RCK) model with dynamic optimization and the altruistic intergenerational links of households. Then, we drop the assumption of intergenerational links in the Blanchard (1985) model and later the assumption of dynamic optimization as well in the Solow model. Our results show that, contrary to the RCK model, public debt reduces long-run output in the Blanchard model and the Solow model, although to a different extent: the crowding-out effect is marginal in the former, whereas it can be very large in the latter depending on the households’ saving rate and the population growth rate. However, we demonstrate that under the conditions of developed countries, even the upper limit of the output loss triggered by public debt is moderate at best. This conclusion holds even if the output loss resulting from distortionary taxes is taken into account. Our main policy contribution is that according to the neoclassical growth models, the long-run burden of public debt around the current 90 percent average debt-to-GDP ratio seems to be of minor importance in the Eurozone.

Keywords: public debt, neoclassical growth models, crowding-out effect

JEL Classification: E13, H31, H63, O40